Choosing an Effective Indicator

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Forex Market News

  • RSI – Relative Strength Index
  • Stochastics
  • MACD – Moving Average Convergence Divergence

What to use, when and why?

Not sure which technical indicator to use and when to use it? I get asked this all the time. Which one is the best or most effective? RSI, Stochastics, MACD?

As a general rule, pick one, understand it, learn how it works and how to use it, and then stick to it. If you feel it’s not working for you, then try another one. Use it in conjunction with what you’ve already been using. You may find one works best for a particular currency or currencies. You may prefer to use another for a certain time-frame. As long as you apply them with a level of consistency, then they should provide you with the information and conviction you’re looking for and need.

However, don’t fall into the trap of flicking through all the different indicators until you find the one that gives you the ‘indicator’ you’re looking for to fit your particular view !  That essentially defeats the purpose of what and why we use indicators as part of our trading strategy.

Let’s step back and ask why we use indicators in the first place.  The name says it all !  They are ‘indicators’.  Not ‘signals’!  Clearly if they were to be used as pure ‘signals’, then they would be called …………. , yes you got it!

We use indicators in conjunction with other studies and technical analysis tools in order to form a sophisticated and informed decision on the direction of a currency (or traded product).  The indicator is used to gives us conformation and conviction in forming that decision or view in order to produce an effective and profitable trading strategy.

Let’s take a look at RSI. Relative Strength Index. This is a Momentum or Oscillator Indicator. It is used to measure the underlying strength of a particular market move. It’s also used to determine overbought and oversold conditions, as well as identify convergence and divergence with the prevailing price action, potentially signalling a reversal.

RSI works best in trending markets and generally over longer time-frames, i.e. daily charts, but can also be used for shorter periods.

Stochastics. These are also classed as a Momentum or Oscillator Indicator. They are used to identify underlying market strength and directional changes in pricing momentum. They are a ‘leading indicator, generating potential signals before they appear in the underlying pricing behaviour.  They generally prove to be most effective when used in ranging markets, but can also be effectively applied to trending markets.  Whilst conveying oversold and overbought market conditions, the relationship between the ‘fast’ and ‘slow’ moving stochastics, primarily crossovers, convey potential reversals and trading opportunities.

MACD. Another popular Momentum Oscillator used to identify overbought and oversold market conditions. It’s classed as a ‘lagging’ indicator and is designed to confirm the existence of a trend. It generally performs best in volatile wide-ranging markets and at the conclusion of strong trending markets. The relationship between the moving averages, the underlying price and the zero or signal line are also used to identify divergence and convergence. A powerful tool favoured by traders.

I recommend trying all three of these indicators at a minimum. Like anything, you only learn how well they work by actually using them.   Everyone trades differently and potentially may also apply these trading tools differently. Again there’s no hard or fast rule of what to use and when to use it ?  It basically comes down to your own personal preference and experience.  Learn them all. Gain the knowledge. Apply the knowledge and through experience it will pay dividends.

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