Trend Indicators: Average Directional Movement Index (ADX)
Average Directional Movement Index (ADX) was developed and described in detail by Welles Wilder in his book "New concepts in technical trading systems". Average Directional Movement Index (ADX) shows if there is a trend on the market and what potential it has.
ADX represents two opposite +/-DM and ADX lines:
The first goes in the direction of the price movement (+DM).
The second goes in the opposite direction (-DM).
The third (ADX) is the absolute difference between +/-DM lines, so the more divergence between +/-DM lines, the greater the value of ADX.
In order to add the ADX indicator to the chart in MetaTrader 4 use the "Insert -> Indicators ->Trend -> Average Directional Movement Index" menu sequence:
Average Directional Movement Index (ADX) signals (table shown below):
Intersection with the extremum lines or reversal at high-low.
+DM and -DM lines intersection precedes a new trend or strengthens the prevailing one - it is a very strong signal.
If +DM line is above -DM line, then the trend is bullish, and vice versa.
If lines diverge then ADX value increases and the trend becomes stronger, and vice versa.
Parabolic indicator (sometimes referred to as SAR) was developed by Welles Wilder in 1976 and was originally called "stop and reverse". The indicator is effective only in a trending market. It helps to define the direction of the prevailing trend and the moment to close positions opened during the reversal.
The closing price (parabolic) is calculated for each bar using the following formula:
Long positions:
SAR (i) = ACCELERATION * (HIGH (i - 1) - SAR (i - 1)) + SAR (i - 1)
Short positions:
SAR (i) = ACCELERATION * (LOW (i - 1) - SAR (i - 1)) - SAR (i - 1)
Where:
SAR (i - 1) � parabolic value on the preceding bar,
ACCELERATION � acceleration factor; for the first bar it is usually 0.20, and then it is calculated as follows:
AF = 0.20 + n x 0.02, where n � the number of new tops (bottoms),
HIGH (i - 1) � high of the previous period,
LOW (i - 1) � low of the previous period.
If a trend is bullish, SAR is below the price chart; if it is bearish, SAR is above the price chart. When the price crosses Parabolic SAR, the indicator reverses and its value becomes opposite to the price. The actual point at which the system is reversed is the high or the low of the previous period.
In order to add the indicator in MetaTrader 4 use �Insert -> Indicators -> Trend -> Parabolic SAR� menu sequence:
Parabolic signals:
When the price chart crosses Parabolic SAR it may be a reversal signal or may indicate temporary consolidation, hence, it is considered as a classic signal to initiate a position.
Parabolic SAR and trend direction are the same. If parabolic moves higher, then the trend is bullish and vice versa.
If there is a significant divergence between the price chart and the parabolic, then their convergence may happen very soon.
When the indicator has completely formed and the Parabolic SAR moves parallel to the price chart, most of the signals will be true; after this, they tend to contract and the number of false signals will be higher.
Trend Indicators: Moving Average Convergence Divergence (MACD) and OsMA
Moving Average Convergence Divergence (MACD)
Some of the disadvantages of moving averages may be avoided by using the Moving Average Convergence Divergence (MACD). MACD is the difference between the fast 12-day exponential moving average (fast EMA) and the slow 26-day exponential moving average (slow EMA). Typically, this is plotted with the 9-day EMA of the indicator itself.
SIGNAL = EMA(9) [MACD],
where
MACD = EMA(12) [p] - EMA(26) [p];
p � price.
Bullish divergence appears when a new price top has not been confirmed by a new MACD top, i.e. price top is above the preceding top and MACD top is below the preceding top:
MACD Bullish Divergence
This signifies that the prevailing trend is weak. However, it is not recommended to open positions against the weakening trend as it is valid up to the moment of reversal. Bullish divergence only indicates that the trend is weak, not that it has ceased. So, before you open a position against the trend, find more significant confirmations that the trend is about to reverse (for example, the breakout of the trend line).
Bearish convergence appears when a new price bottom has not been confirmed by a new bottom of the indicator, i.e. the following price bottom is below the preceding one, and the following indicator bottom is above the preceding one:
MACD Bearish Convergence
This means that the bearish trend is weak but this is not a signal for reversal, so find other confirmations before opening a position.
When the price changes a bit and MACD moves around the zero line, this signals trend continuation.
In order to add Moving Average Convergence Divergence (MACD) to the chart use the "Insert -> Indicators -> Oscillators -> MACD" menu sequence.
In MetaTrader 4 MACD is represented as a histogram (MACD) and a signal line (SIGNAL).
MACD signals:
Levels which follow the signal line top or bottom are the alarms for a deal.
If MACD is below the zero line then trend is bearish, if it is above it then the trend is bullish.
SIGNAL line and price bullish divergence / bearish convergence � a strong sign that prevailing trend is weak.
If MACD is below zero and there is no bearish convergence, and MACD histogram crosses the slow line (SIGNAL) from below, then there are great chances for an upside price rebound.
If MACD is above zero and there is no bullish divergence and MACD histogram crosses the slow line (SIGNAL) from above, then there are great chances for a downside price rebound.
Moving Average of Oscillator (OsMA)
Moving Average of Oscillator (OsMA) is generally calculated as the difference between the oscillator and the moving average on the oscillator. In MetaTrader 4, MACD is used as an oscillator, and a SIGNAL (signal line) is used as a moving average:
Envelopes are formed with upper border U and lower border L. The formula is:
U = ( 1 + u / 100 ) x SMA (P, n)
L = ( 1 - d / 100 ) x SMA (P, n)
where
U � upper border;
L � lower border;
u - % above the moving average;
d - % below the moving average;
SMA (P, n) � moving average.
The percentage ("u" and "d") should be set so that about 95% of price activity is contained within the envelope and 5% outside it. The indicator will then be adequate to the market balance and all prices will come back to the envelope after they exit it.
Bollinger Bands
Bollinger Band is constructed by placing upper and lower bands around a moving average, the band width is not constant but instead proportional to the mean square divergence from the moving average over the specified period of time. Based on the Bollinger Band analysis, the decision to enter/exit the market is made when the price rises above upper BB resistance or falls below lower Bollinger Band support.
If the price moves within upper and lower bands, then Bollinger Band analysis is not a reliable method to determine when the best time to open/close positions is. Once the price penetrates the band to, then come back to the previous levels, then it is considered as the right time to open a position.
Sometimes, when the price penetrates the Bollinger Band and only "tries" new levels, but then comes back right away it may be a false breakout. If it is a true breakout then you have the possibility to trade against the trend. However, it is important to make sure that the breakout is false. In this case refer to the volume because it sharply decreases if the breakout is not false.
Bollinger Bands show the strength of the market:
Bollinger Bands contract when the market is quiet, without sharp price movements, consolidating to continue the prevailing trend or produce a new one.
Bollinger Bands widen when the prevailing trend becomes stronger or at the beginning of a new trend. A good trend confirmation is when bands widen and volume rises.
Moving average (MA) is the average of prices (more often the closing prices) over a specified number of periods. It is a smoothed correlation between currency rates and time periods. The time period of any moving average defines how much it will be smoothed. For example, when a Moving Average is calculated by adding the closing prices for the last 5 bars, then it is defined as a 5-period MA.
When you select a period for the moving average (table shown below) keep in mind the following:
The greater the time period, the less sensitive the MA is to price movements.
If the MA period is too short, then it will have too mane false signals.
A too long MA period will often lag a little.
For sideways trends it is better to use longer than usual periods.
The main advantage of the Exponential Moving Average (EMA) is that it discounts both prices of the previous and current periods. Every subsequent value becomes more significant.
In order to create a Moving Average in MetaTrader 4 use the "Insert->Indicators ->Trend->Moving Average" menu sequence:
This enables the window with the Moving Average parameters:
Specify a period for the Moving Average and select its type (the "MA Method" field). Then press the OK button. This enables Moving Average on the chart:
How to analyze Moving Averages:
Find Moving Average and price chart cross-point. If the price line crosses the Moving Average line from below, then this is a signal to buy. If it crosses from above, then it is time to sell.
Note that Moving Average usually moves in the direction of the prevailing trend.
Find points which occur after Moving Average tops or bottoms. There is a high possibility of a reversal.
Find points where the divergence between Moving Average and price is widest.
If you do not have other confirmations it is not recommended to open positions against the Moving Average's direction.
Moving Average signals are more effective on a trend market and less effective when the market is flat. As MA is a lagging indicator, it gives many false alarms.
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Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends. And although it is important to be able to identify new trends, it is equally important to be able to identify where a trend ends. After all, what good is a well-timed entry without a well-timed exit?
One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal). A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement. From the chart above, you can see that the dots shift from being below the candles during the uptrend, to above the candles when the trend reverses into a downtrend.
Using Parabolic SAR
The nice thing about the Parabolic SAR is that it is really simple to use. Basically, when the dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal. This is probably the easiest indicator to interpret because it assumes that the price is either going up or down. With that said, this tool is best used in markets that are trending, and that have long rallies and downturns. You DON’T want to use this tool in a choppy market where the price movement is sideways.
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MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After all, our #1 priority in trading is being able to find a trend, because that is where the most money is made.
With an MACD chart, you will usually see three numbers that are used for its settings.
The first is the number of periods that is used to calculate the faster moving average.
The second is the number of periods that are used in the slower moving average.
And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
For example, if you were to see “12,26,9” as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:
The 12 represents the previous 12 bars of the faster moving average.
The 26 represents the previous 26 bars of the slower moving average.
The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (The blue lines in the chart above).
There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the difference between the 12 and 26 period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9 period moving average.
This means that we are taking the average of the last 9 periods of the faster MACD line, and plotting it as our “slower” moving average. What this does is it smoothes out the original line even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that as the two moving averages separate, the histogram gets bigger. This is called divergence, because the faster moving average is “diverging” or moving away from the slower moving average.
As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average. And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!
Ok, so now you know what MACD does. Now I’ll show you what MACD can do for YOU.
MACD Crossover
Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one. When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears. This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.
There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it's just an average of historical prices. Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, it is still one of the most favored tools by many traders.
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Congratulations on making it to the 5th grade! Each time you make it to the next grade you continue to add more and more tools to your trader’s toolbox. “What’s a trader’s toolbox?” you say… Simple! Your trader’s toolbox is what you will use to “build” your trading account. The more tools (education) you have in your trader’s toolbox (YOUR BRAIN), the easier it will be for you to build.
So for this lesson, as you learn each of these indicators, think of them as a new tool that you can add to that toolbox of yours. You might not necessarily use all of these tools, but it’s always nice to have the option, right? Now, enough about tools already! Let’s get started!
Bollinger Bands
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract; and when the market is LOUD, the bands expand. Notice on the chart below that when the price was quiet, the bands were close together, but when the price moved up, the bands spread apart.
That’s all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn’t feel like typing it all out.
In all honesty, you don’t need to know any of that junk. We think it’s more important that we show you some ways you can apply the Bollinger bands to your trading.
Note: If you really want to learn about the calculations of a Bollinger band, then you can go to www.bollingerbands.com
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce (smart, huh?). If this is the case, then by looking at the chart below, can you tell us where the price might go next?
If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.
That’s all there is to it. What you just saw was a classic Bollinger bounce. The reason these bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are. Many traders have developed systems that thrive on these bounces, and this strategy is best used when the market is ranging and there is no clear trend.
Now let’s look at a way to use Bollinger Bands when the market does trend.
Bollinger Squeeze
The Bollinger squeeze is pretty self explanatory. When the bands “squeeze” together, it usually means that a breakout is going to occur. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then the move will usually continue to go down.
Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?
If you said up, you are correct! This is how a typical Bollinger Squeeze works. This strategy is designed for you to catch a move as early as possible. Setups like these don’t occur everyday, but you can probably spot them a few times a week if you are looking at a 15 minute chart.
So now you know what Bollinger Bands are, and you know how to use them. There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them. So now you can put this in your trader’s toolbox, and we can move on to the next indicator.
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A moving average is simply a way to smooth out price action over time. By “moving average”, we mean that you are taking the average closing price of a currency for the last ‘X’ number of periods.
Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can make general predictions as to where the price will go.
As we said, moving averages smooth out price action. There are different types of moving averages, and each of them has their own level of “smoothness”. Generally, the smoother the moving average, the slower it is to react to the price movement. The choppier the moving average, the quicker it is to react to the price movement.
We’ll explain the pros and cons of each type a little later, but for now let’s look at the different types of moving averages and how they are calculated.
Simple Moving Average
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A simple moving average is the simplest type of moving average (DUH!). Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X. Confused??? Allow me to clarify.
If you plotted a 5 period simple moving average on a 1 hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5. Voila! You have your simple moving average.
If you were to plot a 5 period simple moving average on a 10 minute chart, you would add up the closing prices of the last 50 minutes and then divide that number by 5.
If you were to plot a 5 period simple moving average on a 30 minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5.
If you were to plot the 5 period simple moving average on the a 4 hr. chart………………..OK OK, I think you get the picture! Let’s move on.
Most charting packages will do all the calculations for you. The reason we just bored you (yawn!) with how to calculate a simple moving average is because it is important that you understand how the moving averages are calculated. If you understand how each moving average is calculated, you can make your own decision as to which type is better for you.
Just like any indicator out there, moving averages operate with a delay. Because you are taking the averages of the price, you are really only seeing a “forecast” of the future price and not a concrete view of the future. Disclaimer: Moving averages will not turn you into Ms. Cleo the psychic!
Here is an example of how moving averages smooth out the price action.
On the previous chart, you can see 3 different SMAs. As you can see, the longer the SMA period is, the more it lags behind the price. Notice how the 62 SMA is farther away from the current price than the 30 and 5 SMA. This is because with the 62 SMA, you are adding up the closing prices of the last 62 periods and dividing it by 62. The higher the number period you use, the slower it is to react to the price movement.
The SMA’s in this chart show you the overall sentiment of the market at this point in time. Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now make a general prediction of its future price.
Exponential Moving Average
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Although the simple moving average is a great tool, there is one major flaw associated with it. Simple moving averages are very susceptible to spikes. Let me show you an example of what I mean:
Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices for the last 5 days are as follows:
Day 1: 1.2345 Day 2: 1.2350 Day 3: 1.2360 Day 4: 1.2365 Day 5: 1.2370
The simple moving average would be calculated as (1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358
Simple enough right?
Well what if Day 2’s price was 1.2300? The result of the simple moving average would be a lot lower and it would give you the notion that the price was actually going down, when in reality, Day 2 could have just been a one time event (maybe interest rates decreasing).
The point I’m trying to make is that sometimes the simple moving average might be too simple. If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods. In our example above, the EMA would put more weight on Days 3-5, which means that the spike on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What this does is it puts more emphasis on what traders are doing NOW.
When trading, it is far more important to see what traders are doing now rather than what they did last week or last month.
SMA vs. EMA
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First, let’s start with an exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go. These can help you catch trends very early, which will result in higher profit. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits!
The downside to the choppy moving average is that you might get faked out. Because the moving average responds so quickly to the price, you might think a trend is forming when in actuality; it could just be a price spike.
With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go.
Although it is slow to respond to the price action, it will save you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good trade.
SMA
EMA
Pros:
Displays a smooth chart, which eliminates most fakeouts.
Quick moving, and is good at showing recent price swings.
Cons:
Slow moving, which may cause a lag in buying and selling signals.
More prone to cause fakeouts and give errant signals.
So which one is better? It’s really up to you to decide. Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.
In fact, many trading systems are built around what is called “Moving Average Crossovers”. Later in this course, we will give you an example of how you can use moving averages as part of your trading system.
Time for recess! Go find a chart and start playing with some moving averages. Try out different types and look at different periods. In time, you will find out which moving averages work best for you. Class dismissed!
Summary
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A moving average is a way to smooth out price action.
There are many types of moving averages. The 2 most common types are: Simple Moving Average and Exponential Moving Average.
Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
Exponential moving averages put more weight to recent prices and therefore show us what traders are doing now.
It is much more important to know what traders are doing now than to see what they did last week or last month.
Simple moving averages are smoother than Exponential moving averages.
Longer period moving averages are smoother than shorter period moving averages.Choppy moving averages are quicker to respond to price action and can catch trends early. However, because of their quick reaction, they are susceptible to spikes and can fake you out.
Smooth moving averages are slower to respond to price action but will save you from spikes and fake outs. However, because of their slow reaction, they can delay you from taking a trade and may cause you to miss some good opportunities.
The best way to use moving averages is to plot different types on a chart so that you can see both long term movement and short term movement.
I am in my mid-forties, an IT professional graduated with BE degree. Career-wise I am in mid-level management role working in a fulfilling job with some traveling in Asian region and some free time available to pursue other interests. I have been trading Forex for the past 4 years. So far, I have busted 2 trading accounts and wipe out $40K SGD. This blog is a record of a renew journey in trading Forex.
(4 Dec 2008)
