Just how profitable is each technical indicator on its own? After all, forex traders don’t include these technical indicators just to make their charts look nicer. Traders are in the business of making money!
If these indicators generate signals that don’t translate into a profitable bottom line over time, then they’re simply not the way to go for your needs! In order to give y’all a comparison of the effectiveness of each technical indicator, we’ve decided to backtest each of the indicators on their own for the past 5 years.
Type: Trend Following
Best used: In combination
To start off, a simple moving average shows the average value of price over a certain period of time. Moving averages is known or commonly used to highlight the direction of a trend and smooth out price to avoid false breakouts, and noise. The best way to utilize moving averages is by combining it with another one. For example, when the 50 day moving average crosses above the 200day moving average this is considered a “golden cross” the upward momentum was confirmed once the short term moving average (50-day) crossed above the longer term moving average (200-day) When the opposite occurs and the 50 day moving average crosses below the 200 day moving average this is considered a death cross as the momentum in price action is declining. Here are a few examples of moving average crossovers.
EURUSD 50sma crosses below the 200sma signaling a death cross. Price fell over 200 pips before closing back over the 50sma.
EURJPY 50sma crossed above the 200sma indicating the trend is bullish with a golden cross. Price action climbed over 500 pips before falling back below the 50sma
2 ) MACD (Moving Average Convergence Divergence)
Type: Trend Strength/New Trend
Best Used: For confirmation with other indicators
The MACD is best used as a confirmation indicator. What I mean by that is that it should be combined with other indicators to maximize its potential. The MACD has 3 main parameters, 12 (which represents the previous 12 bars of the faster moving average) 26 (which represents the previous 26 bars of the moving average) and 9 (which represents the previous 9 bars of the difference between the two moving averages, this is plotted as a histogram. In essence when the faster moving average crosses above or below the slower moving average it indicated a new bullish or bearish trend is forming. Sounds familiar? This is similar to our moving averages crossovers that we discussed previously. Now to best use MACD is to look for a bullish or bearish crossover with the moving averages, once we confirm a crossover we are looking to confirm the trend with a MACD crossover above or below the 0 line with the histogram in favor of our trend. Here are some examples of combining the two to make for a dual threat.
After receiving a bearish crossover with the moving averages we also received confirmation of the downtrend after the MACD crossover to the downside below the 0 line adding further strength to a short position.
AUDJPY shows an early MACD bullish crossover hinting at the possibility of a new trend. Later we received a bullish crossover when the 50sma crossed above the 200sma. To confirm the uptrend the MACD gave us another bullish crossover which occurred above the 0 line.
3) RSI (Relative Strength Index)
Type: Overbought/Oversold measurement
Best Used: Pick Tops/bottoms /Profit taking
The RSI is similar to that of the Stochastic. It is a price following oscillator that ranges between 0 and 100. There are 3 main zones with the RSI (Upper overbought zone ranging from 70%-100%, Lower oversold zone ranging from 0%-30% and middle or neutral zone ranging from 30%-70%. We can help use these zones to pick up potential tops and bottoms depending on the market being in an overbought or oversold position. Along with determining tops and bottoms the RSI can also be used to locate and confirm a trend. Here are a few examples on how to use the RSI.
EURUSD shows price dropping impulsive manner causing the RSI to dip below 30 signaling that there might be no more sellers left in the market and the impulsive move could be over. Price action then reversed and headed towards its bullish direction. This happen twice showing the effectiveness of the indicator.
After GBPUSD made a new high it also showed the RSI in overbought territory indicating the possibility of a decline. We received the decline in price action in conjunction with a bearish trend line keeping sellers in the trade as price dropped over 500pips
4) Bollinger Band
Type: Measures Volatility
Best used: When Market Consolidates and breakouts
Bollinger bands consist of an upper band, middle band, and lower band. When the Bollinger bands tighten and contract the pair is trading under low volality and when it expands there is a great deal of money being pumped into the pair. Bollinger bands differ in the way you can use them in your trading plan here are a few examples on how to trade with Bollinger bands.
Traders can look to buy and sell at the top and bottom Bollinger bands. This method is most effective when the market lacks a trend. Look for the wick of a candle to bounce off one of the Bollinger bands.
Once we see bands squeeze together we look for a breakout with an impulsive candle. Price broke above the top band and continued climbing to the upside giving traders a chance to catch the trade as early as possible.
5) Parabolic SAR
Type: Identify end of Trend
Best Used: Exit Strategy/Stop Loss
Parabolic SAR is a simple tool to use, when the dots are below the candle it is considered a buy signal and when the dots are above the candle it is a sell signal. It is best to combine the Parabolic SAR with another indicator and avoid using it during a choppy market. The indicator is best used when the market is trending.