For new traders, just learning how to navigate the forex market, technical indicators can be a useful tool in figuring out the ropes of the game. Think of them as training wheels. When you set out on your first bike ride, your training wheels helped you balance and build your confidence until you were ready to tackle the sidewalks without them.
Technical indicators work the same way. They help you balance the forex market, as you study the trends and determine how to best navigate them. Just like training wheels though, technical indicators ultimately become useless to the experienced forex trader.
Examples of Technical Indicators
Moving Averages are used to follow trends through price directions, which are tracked based on the time unit that you determine. These indicators can demonstrate changes by days, hours, or even minutes. Forex traders use them to identify when one trend has ended and a new one has started. Once this information is identified, traders can pinpoint the best times to buy and sell. Moving averages are among the most widely used technical indicators.
The Relative Strength Index (RSI) is often used as a compliment to an additional indicator. This momentum indicator contrasts the significance of recent, substantial gains to recent losses. The goal of the RSI is to correctly determine when an asset has been oversold or overbought. With oversold assets, the price has steeply dropped, often to a level that is less than true value. Panicked selling is generally to blame for this market condition. Overbought assets are experiencing the exact opposite conditions. Demand increases the price of an asset to unreasonable levels.
The Commodity Channel Index (CCI) also monitors oversold and overbought assets. This oscillator monitors assets as they move between two extreme values, by evaluating the relationship between price and the moving average. The CCI is a valuable tool for identifying buying and selling cycles. Introduced in 1980, the index has become a widely used indicator among Forex traders.
A Japanese Candlestick is a method of plotting prices to identify movements in currency pairs. Though the method has been popular in Japan for years, it's only recently become a staple of Forex trading in the United States. The process uses two colors and various rectangular shapes to demonstrate the price movement. Due to its ability to provide information with a quick glance, the candlestick is particularly useful for making price predictions. This indicator is best used in combination with other technical indicators.
The Reality of Indicators
How many Tour de France bike riders do you see with training wheels on their bikes? Though most of those riders probably started out with training wheels, they took them off way before becoming professionals. Technical indicators work in the same way and experienced traders know that they are useless. How are they so sure? Dozens of full-time programmers, running thousands of permutations, constantly prove that these indicators don't consistently work.
The biggest difficulty in using indicators is that they are backwards facing instead of forward facing. Indicators tell the story of past performances, and are essentially just records of historical data. Analyzing past periods and using them to correctly predict future periods is a hit or miss strategy. The same indicator can be simultaneously correct in one event and incorrect in a handful of others.
When Forex trainers assert that they have identified a foolproof indicator, buyer beware. This is one of many tactics that are unscrupulously used to reel in new, inexperienced traders. While they enthusiastically show students where their indicators work, the real trick is that they purposely do not show the situations where they do not. Technical indicators are common tools in Forex training, but understand their uselessness and limitations in order to protect your valuable investments.
Learn more about my trading philosophy from my book: The Bull, The Bear, The Baboon – FX Lessons Learned the Hard Way