Using Indicators

One of the first recurring questions when on the first steps of learning how to trade is “What indicator should I use?”.

As it is often the case, when it comes to trading, there is no “one size fits all” solution. The only good advice here is to start small with one or few indicators in order to not get lost into endless data.

We will introduce a list of some of the most widely used indicators, how are they calculated and some basic trading strategies.

Bollinger Bands aim to offer a relative definition of minimums and maximums. As per definition, the prices are high in the upper band and low in the lower band. This definition helps highlighting t
he patterns and comparing the price movement with respect to the indicator movement in order to help making trading decisions.

This is how the indicator is structured:

Upper Band = Medium Band + 2 Standard Deviations

Medium Band = M
oving Average (20 periods)

Lower Band = Medium Band – 2 Standard Deviations

Bollinger Bands on GBPUSD

There are many trading strategies that can be applied using this indicator but we will cover the two most common:

Scalping Strategy

When prices reach the upper band, a bounce back of the prices within the band is quite possible and it often leads to a price fall. This would be a good moment to enter short and then exit short after with a profit. The more the price pushes up the upper band, the stronger the selling signal. The opposite case is also valid as the prices pushes down the lower band. The strategy is more robust when combined with other indicators like RSI.

Dynamic Trading Strategy

Before one starts trading, a clear ascending or descending trend must be identified.

When a bearish candle that closes outside the lower Bollinger Band is identified, we need to wait for a bullish candle that closes again outside the lower band and below the moving average. The fulfilment of these conditions suggest entering long and then close when the next candle touches the moving average. Same logic applies for the opposite pattern that starts with a bullish candle.

The strategy can be customised with other indicators or oscillators like the RSI in order to filter cases when the traded instrument is overbought/oversold.

RSI stands for “Relative Strength Index”. This indicator is used to measure the minimum price variation and determine if un instrument is overbought or oversold.

The standard period used is 14 but it is adjustable. By increasing the number of periods, the indicator will become less “reactive” will less sharp curves and vice-versa if the number of periods is decreased.

The RSI appears on the chart like one line that oscillates between 0 and 100. The key levels are 30 and 70. Below 30 the instrument is overbought and above 30 it is oversold.

RSI Relative strength Index on EURGBP

Trading Strategy: Divergent RSI

Many traders look at RSI for its overbought and oversold indications which is why RSI is often used in combination with other indicators. While watching out for these points, it helps to also search for points of divergence by comparing the chart itself with the RSI line. A divergence point is encountered when the price is moving to the opposite direction of the indicator such signalling a potential inversion of trend.

When the price of the instrument touches a lower minimum and RSI a higher one than we are dealing with a bullish divergence. If the RSI does not confirm the descending minimum of the price, then we are experiencing a strengthening of the momentum of the trend which will form an upward trend. So to summarise, the trend with divert if not confirmed by the RSI and follow the latter on both bullish and bearish divergences.

CCi, Commodity Channel Index, can be used on any market regardless of what the name suggests. This indicator measures the current price compared to an average price of the high, low and close for a given time. The formula includes a constant, 0.015, that allows the indicator to oscillate between the -150 to 150 range for 75% of the time.

CCI Commodity Channel Index on GBPUSD

Classic Trading Strategy

The classic strategy is to sell when CCi goes beyond -100 and buy when beyond +100. On the other hand, one should close when the CCi goes to the other end of the scale, for example the long position should be closed when CCi goes beyond -100.

Multi Timeframe Trading Strategy

First, the primary trend must be established on a long timeframe chart while we look for pullbacks and entry levels on a short timeframe chart.

When the CCi moves above +100 in the long term timeframe chart, the trend is bullish so then we move to the short term timeframe chart and look for bullish signals.

In the short term chart we only buy when CCi goes below -100 and then returns above that level. We exit the position when CCi jumps above 100 and then goes down again.

SAR is a mathematic model based on the relationship between time and price. Its objective is to find trend inversion points (Stop and Reverse). SAR is similar to the Moving Average but it changes in that it moves on the chart without intersecting with the prices.

Basic Strategy of SAR

When the designed inversion dots of SAR are under the price then one should go long and vice-versa.

This is perhaps one of the easiest indicators to interpret because it limits itself to pointing either upwards or downwards. Despite its simplicity, in moments of strong trends SAR can lead to very good gains.

Parabolic Sar ( Stop and Reverse) on Crude oil

Managing Positions with SAR

The position is closed when confirmed by a formation of at least three dots from SAR.

The Moving Average creates data subsets and compares them to the full data set. It predicts whether the trend will continue or reverse instead.

Choosing on which Moving Average to focus is essential. Let’s illustrate two types of MAs, Short term (8.21.55) and Long Term (100 and 200). The long terms ones are more common while the short term ones vary more for each trader since it depends on what time frame one is trading and how many signals one would like to receive.

Moving Average strategy

Trading Strategy: Intersection of Moving Average and Prices

A simple system would be to look for trading signals at the points where the MAs intersect with each other. In the below chart you can see an 8-period (blue) MA intersecting with a 21-period one (green). A buying signal is created when the short term MA is rising from below such overtaking the long term MA. If the short term MA falls below the long term one, then one should enter short instead.

On the other hand, if longer term MAs are used, the benchmark should be the line of the price itself.

Moving Average Convergence Divergence (MACD) is used to identify trading opportunities where there is a possible inversion of the trend.

The MACD compares two MAs, the 12–period and the 26-period one.

The calculation formula is simple: 12 period MA – 26 period MA.

MACD ( Moving Average Convergence Divergence) on EURUSD

In 1986, Thomas Aspray decided to insert histograms of the difference of the two MAs and the signal line of 9-periods knowns as EMA (Exponential Moving Average) inside the MACD chart. The histogram is positive when the MACD is above the EMA and vice versa. The quicker a trend develops, the longer will the bars of the MACD be.

Trading Strategy

When MACD moves above the EMA it signals a bullish trend and vice versa.

Momentum may come very useful when we need to measure the velocity of the trend while also assessing its strength in order to anticipate a possible inversion.

Momentum
The difference in the current price and the number of periods are taken into consideration for the calculation. The indicator’s values are negative when the previous price is higher and positive when lower. In order for the indicator to be a good representation of the momentum, values should usually be between 8 and 14 periods. Below these range the chart curves might get too sharp and generate false signals while above it they may get too rare such making the analysis less realistic.

Trading Strategy

Momentum can be useful to pick up small trend variations within a main trend but it is mainly used for strategies that are based on the divergence between the indicator and the price.

This is one of the main indicators used by the new traders and can be used on multiple timeframes.

In the chart below you can see it in green when the trend is bullish and red when bearish.

The most common use of the indicator is managing open positions as if it was a trailing stop. The calculation based on two parameters, one for the period in consideration and the other is a multiplying coefficient of volatility. The default parameters are 2 for periods and 3 for the multiplier.

Supertrend on EURUSD

The indicator has a lot in common with SAR. Its main advantage on the latter is that during the sideways phases, the indicator keeps some sort of standby positions such not running the risk of exiting a position too quick due to false signals.

Stochastic measures the upsurge of a movement by comparing the closing price to the trading range in a given period to the maximum and minimum price. It is observed that when the closing price is close to the maximum, the trend is usually bullish and bearish when close to the minimum.

The indicator ranges from 0 to 100 and marks overbought and oversold areas using two lines:

The K percentage line ( %K) = {(CLOSE – MINn)/(MAXn – MINn)}
Where:

MINn – The minimum of the last n days

MAXn – The maximum of the last n days

CLOSE –Closing price of the day

The D percentage line (%D) – A moving average of the %K used to filer its movements.
In order to avoid false signals, the 20-5-5 parameters are usually recommended.

Stochastic on Gold

Strategy during sideways trends

Once we have drawn the support and resistance levels, we look out for a situation where the price touches the support and the two stochastic lines intersect in the oversold area and buy. The opposite scenario – where the price touches the resistance level and the two stochastic lines intersect in the overbought area – is a signal to go short.

Pivot Points embodies the averages of the maximum, minimum and close prices within a given number of periods.

The chart traces:

Three support lines S1, S2 and S3
Three resistance lines R1, R2 and R3
The pivot point line

Pivot Points

The indicator is used for two main purposes

The first one is establishing a trend. If the price is above the Pivot Point line the market is bullish and vice versa. It is worth noting then when the trend is weak the prices tend to rebound while they keep on breaking out the indicated levels when the trend strong.

Intraday Strategy

Once the main trend is identified using usually a daily or weekly timeframe with either Pivot Points or two Moving Averages, the daily Pivot Point should be inserted on an hourly chart and trades are inserted only in sync with the main trend. So for example, if the main trend is bearish, we look out for times where the prices goes upwards and bounces off R1 so we can enter short and the closing target would be S1, S2 or S3.

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