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Technical Analysis Tools: Using Technical Indicators
Price charts
Price charts can help a trader identify if there are any trends to be seen in the market that they can use in their trading decision. Technical Indicators help them analyze how strong and how sustainable these trends are. If therefore, you find one trend that is suggesting a reversal in the market, you should wait to confirm that this is so before rushing to make a trade. You may have to wait for another period to confirm the indicator is correct or you may need to verify using another indicator. By being patient and thorough, you will be able to read and interpret the signals accurately. We will now see how some of the technical indicators we had mentioned above may be used to understand how the market is moving.
Moving Averages
These are one of the most widely used indicators and they help traders in a variety of ways - by identifying trends that are still emerging, by confirming trends that are already existing and by monitoring long term trends which may be about to reverse. All the short-term fluctuations are noted down on a price chart but then smoothed out so that the long-term picture becomes visible. This smoothing is done by taking averages over certain periods and hence the term 'moving averages'.
There are different ways in which the averages are calculated. A simple moving average is one in which each price point is given equal weightage, the trader specifies whether the high or low is to be used and the average of the price points over a particular period is calculated. On the other hand, in a weighted moving average, the latest prices are given more significance. This makes the averages more realistic since the recent price changes are given more importance.
The calculation of the moving averages is the simplest part - the tricky part is identifying which period length and which moving average you would like to study to give you a realistic assessment of the current market. Once you find the correct combination, you will clearly see the trend developing. Typically traders will compare a few time frames of the moving averages over a chart that has been compiled over many years. You can then see for yourself how well the timeframe that you chose signaled the changes and make adjustments that you feel fit.
Now that you have found a moving average that you have confirmed works well for the currency pair of your choice, you can treat this as a line of support below which you will not sell and as a line of resistance beyond which you will not buy. If however, the prices do cross this line, you can take it as an indicator that the currency is changing directions.
Stochastics
Stochastic Studies are also called oscillators and they monitor a trend to see its strength and sustainability. Any changes could mean reversals in the price positions. Stochastic indicators are of two types - %D and %K, being measured on a scale of 0 to 100. %D is the slower indicator and takes some time to indicate any change while %K is the more sensitive one and can show immediate changes.
Relative Strength Index
The Relative Strength Index or RSI is also used to verify the strength and sustainability of certain trends. This index measures the momentum in price movements and is again measured on a scale of 0 to 100. If an RSI stays at very high or very low levels, you can be sure that the markets are not going to be changing directions soon and are either too strong or weak.
You have to determine the RSI for the timeframe that you are interested in. While short-term RSI tends to be a little volatile, for a day trader, that may make perfect sense. On the other hand, if you are here for the long haul, you may want to have a longer-term RSI.
Similar to the Stochastics, any divergence between the trend of the prices and RSI may suggest that there will be a reversal in the current trend.
Bollinger Bands
These are volatility curves that typically identify the high points and low points in price movements. The moving average of a currency is identified, certain set deviations are specified around this moving average and bands are created giving the curves their name.
If a current price is touching the low or high band, it does not mean that there is any imminent danger of a trend reversal. As the volatility changes, the Bollinger bands tend to adjust accordingly so when the prices get very volatile, they will touch the band.