Trend indicators are used to detect the direction of the trend in a manner that is as objective as possible.
Trend indicators make use of price data over a time frame, and smoothe out this data into a representation on the charts that can immediately show when prices are trending upwards, downwards or sideways.
Trend indicators are lagging indicators because they tend to follow the price and are not predictive in nature. That is why they tend to produce signals that are not reliable on their own. They always need to be used with some kind of confirmation to improve their accuracy and reliability.
Here are five important trend indicators you should know about.
The moving average is considered as the number one trend indicator in the forex market. The moving average is an arithmetic mean of the closing prices of a currency pair within a certain time frame. This arithmetic mean is smoothed into a single line and plotted on the chart as a moving average line. When you hear of a 200-day moving average, it simply means it is a moving average that was calculated using the closing prices of the asset over 200 days.
The use of single moving average lines does not produce the best signals as they tend to lag the market and produce a lot of fakeouts. To solve this problem, market experts came up with a system where two or three movie averages are combined to filter the signals. One of such methods is by using two or three moving averages of different time ranges in a crossover fashion. By allowing the cross of a short moving average above or below the longer-term moving average, traders can filter out signals that have come too early or signals that have come too late. The crossover strategy has proven to be one of the best strategies for trading with moving averages.
There are different types of moving averages. There is the simple moving average, the exponential moving average and the volume weighted moving average. Each of these types of moving averages have their place in the financial markets. It is up to the trader to discover the best application of these moving averages in their trading work.
The Ichimoku Kinko Hyo indicator is a complex indicator that found wide usage in the financial markets of Japan and other areas of the East. It is a multi-faceted indicator that is made up of several components. The most important components are the Tenkan line, Kijun line, and the cloud or Kumo. These three components alone can produce a variety of some of the best signals in trend trading.
Signals tradable with the Ichimoku include the cross of the Tenkan Line over the Kijun Line (similar to the moving average crossover), or the break of price above or below the Kumo. The borders of the Kumo can also be used in support-resistance trading.
The moving average envelope is a trend indicator which was developed by Bill Williams. It makes use of three moving averages: The envelopes are a pair of lines which are set at a given distance above and below a moving average line. The distance of these lines are derived from a percentage-based calculation. These lines therefore form parallel lines that track the movement of the moving average, which serves as the basis for the movement of the indicator.
Typically, the use of an exponential moving average places more emphasis on price action that is more recent, which produces less of a lag than if a simple moving average was used. The default setting on the ThinkMarkets MT4 is for the simple moving average, used with a period of 14 days and a deviation of 0.1% for the accompanying envelope lines.
The envelope settings should be such that the lines encapsulate price action. The envelopes and the moving average will turn in the direction of the trend. Price breaks above the envelope in a downtrend, or below the envelope in an uptrend are considered significant and may precede trend changes.
The Parabolic SAR (stop and reverse) indicator can provide important points for trade entry and exit. The previous day’s data can be used to derive a stop loss position before a new trade is set up. This stop level continues to move with price until it appears on the opposite side of the indicator’s line. A stop level that appears below the price is a long entry signal, while a stop level that shows above the price is a short entry signal. This only works in trending markets.
The disadvantage of this indicator is that it is prone to whipsaws. It must be combined with other trend or momentum indicators to improve its accuracy.
The Bollinger band indicator was discovered by John Bollinger and consists of three bands: an upper band, a lower band, and the middle one that is equivalent to the 20-day simple moving average. The Bollinger band is a trend following indicator which is able to detect periods of reduced volatility (also known as a Bollinger squeeze) and periods of wide volatility.
The breakout from the Bollinger Band squeeze is one of the best signals to trade with this indicator. However, it must be combined with the use of another indicator or a candlestick pattern that can both detect fakeouts, as well as signal genuine breakouts. For instance, if the 2nd of a bullish engulfing candle extends below the lower band in a squeeze situation, this is not a signal to go short but is indeed a fakeout. However, you can use a momentum indicator to gauge the buying or selling pressure and hence the direction of the breakout from the squeeze. For instance, progressively rising troughs of a momentum indicator’s signal line could indicate that a Bollinger squeeze will terminate in a bullish break.
The Bollinger bands can also be used to detect buying opportunities at the lower Bollinger band and selling opportunities at the upper Bollinger band. Short-term exits for long and short orders may also be attained using the middle Bollinger band as the possible point of trade exit.