Forex Indicators Explained: How to Use Indicators in Forex Trading

There are few tools in forex trading more empowering than market indicators. Forex indicators help you to better understand current market trends and price action. If you can learn to interpret this data and any subsequent trading signals, you’ll be best placed to make informed trading decisions on any forex pair.

Within this guide, we explain how to effectively use indicators as part of your overall forex trading strategy.

What Are Forex Indicators?

Forex trading indicators are analytical tools that allow you to digest price action and pinpoint potential trends in the forex market. When you find the right forex indicator, you’ll get a genuine feel for the current market behaviour, which can help you to anticipate the future price movement of a forex pair.

Forex indicators can be grouped into two categories:

Technical Indicators

Technical forex indicators generally explore historical price data, plotting low and high prices, as well as prices at the opening and closing of markets. Technical indicators are also a valuable gauge of trading volume. They lean heavily on math-based formulas to spot trends and patterns in the market to define potential entry and exit points for trades.

The most common examples of technical indicators for forex traders include:

• Moving Averages
  A basic Moving Average is a trend line which smooths out price data over specific timeframes.
• Relative Strength Index (RSI)
  An RSI gauges the speed and severity of price movements to pinpoint overbought or oversold market conditions.
• Bollinger Bands
  These bands are designed to showcase price volatility and identify potential breakout areas from support or resistance levels.

Fundamental Indicators

Fundamental forex indicators digest real-time macroeconomic data and monitor the latest geopolitical events. Both can have serious implications for the value of fiat currencies around the world.

The most common examples of fundamental indicators for forex traders include:

• Gross Domestic Product (GDP)
• Interest Rates
• Employment Data

Key Technical Forex Indicators

We’ve briefly touched on some of the most popular technical indicators among forex traders, but let’s go into more detail about their purpose and how forex traders interpret them:

• Moving Averages
  Moving averages are vital for spotting trends in forex markets by smoothing out volatility in price data. Simple Moving Averages (SMA) monitor the average price over a set timeframe. Meanwhile, Exponential Moving Averages (EMA) give weight to the latest price data, making them more responsive to price changes. Forex traders lean on SMA and EMA indicators to gauge trend directions and potential reversal points for trade entries and exits.
• RSI
  The RSI is a momentum oscillator calculating the speed and size of price moves on a sliding scale from zero to 100. Anything over 70 indicates a forex pair is overbought, i.e. overpriced. Meanwhile anything under 30 suggests a forex pair is oversold, i.e. undervalued. RSI is handy for finding divergences between price action and momentum, which often signals a market shift.
• Bollinger Bands
  A Bollinger Band contains three lines – the first is an SMA in the middle. Then there’s one line above and below the SMA. The top line is one standard deviation above the SMA and the bottom line is one standard deviation below the SMA. When prices touch or move beyond the bands, it can confirm a reversal or continuation of a trend.
• Moving Average Convergence Divergence (MACD)
  The MACD indicator is based on the relationship between two moving averages to provide a trend-following momentum indicator. These are usually the 12-day and 26-day EMAs. The MACD line and the signal line, usually the 9-day EMA, interact to show alterations in market momentum. If the MACD moves above the signal line, it’s often a bullish move and it’s similarly bearish if it falls below the signal line.
• Fibonacci Retracement Levels
  Fibonacci Retracement Levels are drawn using classic Fibonacci ratios which can determine support and resistance levels during price retracements. Traders will use these levels to identify optimal entry and exit points, since prices regularly decelerate or reverse near these key levels.

Key Fundamental Forex Indicators

Now that we’ve covered the best technical forex indicators in more detail, let’s explain the essential fundamental indicators that every forex trader should watch:

• Geopolitical Events
  Political stability, trade agreements and global events can significantly impact forex markets. Whether it’s general elections, wars or trade disputes, all of these can lead to volatility in currency prices. It’s vital to stay abreast of geopolitical developments as they can create trading opportunities as well as risks.
• Interest Rates
  The central bank of every nation sets the interest rate for lending which can affect currency demand. Higher interest rates tend to occur during periods of high inflation, while lower interest rates occur during periods of low inflation or deflation. Generally, the lower the interest rate, the weaker a country’s currency will be.
• Economic Reports
  Economic indicators like Gross Domestic Product (GDP), employment and unemployment data and inflation reports offer immediate insights into a nation’s economic health. Growing GDP or strong employment figures will often strengthen a currency.
• Market Sentiment Indicators
  One of the best forex sentiment indicators that exists is the Commitment of Traders (COT) report. Using this information, you can analyse the positions of the biggest market participants. By understanding market behaviour, you can attempt to second-guess the market and pinpoint a price reversal.

Combining Indicators for Better Forex Strategies

The forex market is one of the most dynamic of all the available asset classes to trade. As such, leaning too heavily on one type of indicator will often lead to you falling short and misreading the market. The best forex indicator combination is a fusion of technical and fundamental signals, giving you a broader understanding of market conditions, thereby improving the accuracy of your entries and exits.

Technical indicators like Moving Averages and RSI look at historical price data to suggest trends and momentum. You may look at the 50-day Moving Average to spot the prevailing trend and use the RSI to confirm if the currency appears overbought or oversold. This can help empower you to either enter, exit or hold an open position.

Fundamental indicators like central bank interest rate announcements, employment data and GDP growth add context to the economic conditions influencing a currency’s value. You may watch a bullish trend using technical indicators but fundamental indicators, like a projected interest rate hike, could bolster your confidence in a long position.

Some forex traders will look to use geopolitical events with Fibonacci Retracement Levels. If a currency pair approaches a key Fibonacci level and positive economic data aligns, it increases the chance of the currency pair’s price breaking through a resistance level.

Ultimately, merging your use of technical and fundamental indicators gives you a more holistic view of the forex market, with a greater understanding of numerical patterns and real-world influences.

Common Mistakes When Using Forex Indicators

Some forex traders make the same mistakes when relying on technical indicators as a basis for their trading decisions. Let’s run through the four most common scenarios to help you see the bigger picture and know what to avoid:

1. Some traders rely too heavily on a single indicator, leading to biased decisions and missed opportunities.
2. By focusing on technical analysis and ignoring fundamental market drivers, this can also compound the issue further.
3. Some traders misunderstand the difference between lagging and leading indicators, which can lead to delayed responses to market movements.
4. Finally, a failure to back-test strategies using indicators can also lead to inherently flawed trading plans.

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FX Trading Indicators FAQs

What is the best indicator for forex trading?

Picking the best indicator for forex trading is entirely subjective. Ultimately, you should trial as many indicators as you can. By doing so, you’ll get a feel for the ones that help you to understand the market as quickly and accurately as possible.

What is the best forex scalping indicator for short-term trades?

If high-frequency trading is your bag, there are a handful of scalping indicators worth testing. Volume-Weighted Average Price (VWAP) shows a trend line and when the market value is above this line it suggests a bullish trend. When it’s below the line, it typically denotes a bearish sentiment. There’s also Exponential Moving Average (EMA) which looks at a moving average based on recent prices over the latest candles which, in theory, offers a more accurate short-term buy or sell signal.

Do I need forex indicators to trade?

No, you don’t have to use an fx indicator to trade the forex markets. However, they are a very useful tool in your trading arsenal to attack the markets and make informed decisions based on market sentiment and momentum.

What are the pitfalls of relying on forex indicators?

Even the best forex sentiment indicators have their limitations. Although they can throw up potential entry and exit points in the market, there’s also the potential for false signals to occur. Overreliance on technical indicators is also a major issue. You should never lean on any forex indicator to solely inform your trading decisions. Couple them with solid fundamental analysis to get the broader market context before you dive in.