Forex Indicators

Incorporating the Right Indicators Into Your Trading System

Technical traders are not making decisions on any other input but their set of indicators and rules. As a holistic approach, it is a trading system that combines position or risk management, chart analysis, and volatility/volume parameters, producing three types of signals: enter a trade, exit a trade and do not trade. Technical traders’ decisions are therefore based on a black and white mindset. In other words, their mind is not different than the trading systems they have made.

On a professional level, their mind is just thinking about testing out more to improve the system effectiveness on the forex market. This article will reveal an important view of how to add on an element or an indicator to a system that already has a few synergetic elements, each playing their role, and measure various categories from the market numbers. Using an example from one professional prop trader system structure, we can give an understanding of what to look for when improving your own trading system. 

Technical traders may follow a certain theory, using just John Ehlers’s indicators, for example, but it is proven that risk is mitigated by diversification. Even though the indicators from this researcher are somewhat predictive in nature, having another indicator from other theories that base on historic confirmation might be not only risk-mitigating but also create special chemistry when combined. Traders that are advanced already have a system and are probably familiar with the theories or how their indicators are made. Beginner traders are not familiar with this, and actually, they do not have to be to create effective systems. We will present you with a few shortcuts to finding this special indicator combination.

As an example, a trading system can have a volatility indicator based on which position size and risk management are based on. Having such a variable and adaptive way of controlling risk is imperative as discussed in other articles. ATR indicator is one such volatility measure. The next element in the system is a specialized volume or volatility indicator whose role is to tell us when there is not enough momentum in the market or trend and to just ignore signals from other indicators as the risk of price changing direction is increased. We are looking for quality trends to follow, a scientifically proven method of trading with the best results. When we are looking to exit a position, technical traders also make decisions after an indicator. This type of indicator should be great for finding points when trends exhaust and some think oscillators and reversal indicators are a good pick for this role.

A separate article also explains this in more detail. At the core of the system is the confirmation indicator, when to enter a trade is a starting point when we look at charts. Finding an indicator that proves to be very effective at finding emerging trends is a precious element but we all agree none is close to being right even 70% of the time. As this is the core of the system, why not make it better by adding an additional confirmation indicator? Having two different experts will generate better solutions than just one. Now, if we go on we might think more is better, but there is a thin line after which adding more indicators creates a detrimental effect on the system. It is too complicated. So adding just one additional confirmation indicator is enough. The point here is to make sure that the first trend confirmation signal is not a fake market move that just a whipsaw, so add another one that needs to produce a signal in the same direction before we make a trade. Eliminating losses from these fake moves has the same effect on our account as when we win. 

Confirmation indicators have various calculations, formulas, and ideas behind them, and that is great. As an analogy let’s say your system is a team of players. Each player has its role but we have all witnessed a magic bond between two or more players that are just extremely effective when combined. Of course, having a bad player and another bad player is going to be better but it is no-brainer because we want to have two greats. Finding great indicators is a long and tedious work, once we have one with the best backtesting and forward testing results, it is priceless. The ones that got to the top 10 of your list might be the ultimate additions to your number one. The good thing about these indicators is that they are abundant, unlike the volume indicators, and they are easy to test. 

Trend confirmation indicators can be categorized to make this process beginner-friendly. Starting with the Zero Cross indicators, they are generating signals based on a line crossing a horizontal zero value line. A typical example of this is the Chaikin Money Flow (CMF), an indicator using volume and other market values in its formula. After all, traders are interested in how good it is for their system after backtesting and forward testing. When the main signal line is crossing the zero line it means a new trend or continuation is starting. If your main confirmation indicator is from the same category, you will need to change one to get the diversification effect.

The second category is the Line Cross-type. These are probably the most common type of indicators. MACD can be one example of this, although MACD also has a zero line. If you want to diversify, you will need to pay attention to different signals even the  MACD, for example, belongs to the Zero Line and the Line Cross category. The third category is the on chart indicators. Now, these indicators are the ones when applied are represented on the MT4 chart itself, not in a separate window below it. Moving Averages are a simple example of this type of indicator, and there are many ways you can classify a trade signal with them. Many systems have them and they can be an extremely effective tool. Finding the right Moving Average indicator is surely going to be worth the time. 

Now when we understand how to combine and diversify indicators, understand that the second confirmation indicator is there to filter losses made from the main one. Since cutting losses is the same as generating wins, we are looking for synergy results where the second indicator is filtering the losses but not filtering the wins. Volume indicators have a similar role here but know it is hard to find a volume indicator that does not filter a win in the way. The nature of measuring volatility or volume simply needs more data to be effective, consequently, they lag. Lagging may cause your system to miss the right moment to enter a trade and therefore a possible big win but this is just something we have to accept.

Additional confirmation indicators are not necessarily like this but they still add value to your system. Traders’ focus should be on cutting the losses, it is the main problem once you make your first system. When we find and adjust our second indicator, aim to cut a lot of losses. If a winner is filtered, try to adjust settings a bit but not at the cost of letting the losers in. As we have discussed in previous articles, your indicators should be recent, do not latch on to the popular ones, you will soon find others have better results in your testing. Combining different type indicators with great results is the way to go but know that sometimes the synergy might not be there. Similar to sports, you may collect the best players together in a team but the result can be disappointing. On other occasions, two great players that understand each other can beat the opposition alone. Interestingly, case studies have shown each had a different specialized skillset that adds value to the other. The goal is the same but the formula is based on different measures and the representation is different. 

You will find many times that your two confirmation indicators do not align, and this is good. Pay attention to the main setting adjustment you can make, the period. By having one faster and one slower confirmation indicator, you may find that sweet spot of filtering losses and keeping the winners. Whatever confirmation indicators you find, only testing will show you if this combo is worth keeping. The more pairs you test, the better the odds you will find a golden team. Other elements in your trading system should not be messed with during testing, you need to have control and compare only this confirmation indicator combination.

Here is an example provided by one prop trader demonstrating how this idea works in practice. We are going to use the EUR/USD currency pair. It is the most traded pair with many news, reports, and event that could push the trend the other way. As such it is considered the riskiest pair you can pick and should provide a lot of losses and wins. Losses we should cut by introducing a second confirmation indicator. From the picture below we can see our Aroon indicator is really having a hard time finding a winner. This chart is very nasty for trading trends with many whipsaws.

Red and green vertical lines are added once the indicator gives a signal to go short or long. Aroon was able to give us approximately 3 wins and 8 losing trades. We can see Aroon is a line cross indicator type, signals are generated once the red line crosses above the blue for short and vice versa. Let’s see what happens when we add a second confirmation indicator not belonging to the line cross-type. 

We have added an Exponential Moving Average for 20 periods as the on chart type indicator. Now if you use the EMA for generating signals only when the price crosses it, you will find many conflicting signals with the Aroon. When they are in conflict, we do not take that trade. When we take this rule to the chart, many of the losses are filtered. 

Now we have kept the winners and have only 6 losses. EMA might not give us great loss reduction but the end result is still better than before. Let’s try to find a better indicator. 

We have added the Force Index indicator and adjusted its period to 26 from the default 13. Additionally, a horizontal line is added at zero effectively making this indicator a zero line cross type! The result is we still have 3 winners and now only 2 losses. Before all this, we had 8 losing trades. So we have transformed our system from a 27% success rate to 60%. Note that your system still has a volume filter and other elements that boost this rate to a much better percentage. With good position sizing, money management, you should be profitable. You now have better odds than a 50-50 coin flip.

By the way, having proper money management and using a 50% success rate system can still yield profits. Just pay attention, what is presented is just a couple of trades on a single currency pair. What you need to do is test your indicator combinations on longer periods and other assets. We are aiming to create a system that works on every currency pair, without adjustments. The final product is a universal system you can use professionally for a long, long time. 

To conclude, the hard work you have to put in is necessary to find that perfect combo. Treat it like a treasure hunt, a game with real treasures behind. If this is exciting to you then it is just a matter of time when you complete your trading system and just trade as it says, consistently providing you with treasures. Your score list of tested indicators is useful, you can pick up your second confirmation indicator from there without searching through the forums and indicator websites. Use the tricks described here, add a line, test different periods and settings, add an MA to the indicator. Finally, the synergetic effect is easy to test, as demonstrated, you will not spend too much time to figure out you have a high % combo in front of you.

Forex Indicators

Using Volume and Volume Indicators for Swing Trading

Volume is the lifeblood of forex trading but is often misunderstood and many traders don’t know how to use it to their advantage. If you imagine the market as an organism, then volume is the life force pumping through its veins and, without it, everything would gradually grind to a halt and the market would die. And yet, in spite of its importance, it still gets viewed as a somewhat unattractive part of a trader’s toolkit and is often misunderstood, misused or misrepresented. Sometimes all three. But the fact of the matter is that every consistent and successful trader will have a volume indicator that they know and love firmly integrated into their system and will check it religiously before even thinking about entering a trade.

Volume Confusion

Put simply, volume is the measure of how much of something is being traded. So far, so good. But there’s the rub. People still manage to confuse volume with liquidity, volatility, and momentum. This confusion is perfectly understandable actually. These things are all closely interrelated but they are not ultimately the same thing. A good and easy-to-remember way to think about it is that volume creates liquidity and, to a certain extent, volatility. And it certainly influences momentum.

But while you need volume to be able to trade (more on that later), this isn’t the same thing as needing volatility to trade. Just because you need a certain amount of volume coursing through the veins of the market, does not mean to say that you should be looking for the most volatile or liquid pairs and trading those. It’s important to remember this because the close interconnections between these phenomena mean that many people confuse them in their mind.

The thing to take away from all of this is that a higher level of volume shows that there is some gas in the tank and the market is more running better. This is important because the level of volume can show how robust a particular market move is, which can (along with your other indicators) give you a green light on a trade entry. To keep things uber-simple, the more volume during a price movement, the more legs that movement has got. If there is less volume, the movement is likely to lack conviction.

Why Use a Volume Indicator?

Since volume is what makes markets trend, it is crucial for technical traders and trend traders. This is not news to most people but somehow some traders try to trade even when volume is low and then come away scratching their heads when their roster of losses starts overtaking their wins. A volume indicator is just a mathematical tool that visually represents in your platform whether volume is high or low. Be careful because different indicators use different formulas, which changes how useful they are and how they are used.

A good volume indicator can cut down on the losses you will make if you enter trades when the market is running low on gas. Sure, eliminating losses is nowhere near as exciting as finding an indicator that will help you to find wins but a smart trader will be able to see the benefit immediately. The fact is if the market conditions aren’t right and your well-constructed, thoroughly tested system tells you to not trade – you’re already kind of winning because you’re not taking the hit of an unnecessary loss. You win if you don’t lose and you can’t lose if you chose not to play. That’s why you need a good volume indicator. It is key money management and risk management tool and, if you use it right, you will see how it impacts your bottom line.

So, what should a good volume indicator do?

In short, it needs to tell you whether there is enough volume to trade. Think of it as a stoplight. If it’s green (and all your other trade signals align), go ahead and enter the trade. If it’s red, however, that’s your cue to pull out of the trade. A good volume indicator will do both of these things. Another thing to keep an eye on is indicator lag. Some lag is inevitable – all indicators lag to a greater or lesser extent – but you don’t want your volume indicator to lag too much so watch out for that when searching for and testing volume indicators.

It’s just not possible to overemphasize this: if your volume indicator says there isn’t enough volume in the market at the moment, do not trade. Just like when you’re driving, you don’t hit the gas when the light is red, you don’t trade when there isn’t sufficient volume. There are a lot of factors going against you in forex trading – you can’t predict the future, you can’t control the odds of a trade going your way, you can’t influence the big players in the market … the list is endless. But one factor you can control is when you trade. If you feel – or better yet, if you calculate in a rational and systemic fashion – that the odds of a trade are not in your favor, the only smart option is to not enter that trade. It’s not that different from seeing the cards in front of you in a game of poker, figuring out that another player is likely to have a stronger hand, and choosing to fold. We could take the analogy further and figure out what a volume indicator would be in poker but that isn’t necessary – the thing to take away from this is that a good volume indicator will tell you to avoid the trades that you should be avoiding anyway.

Loss Aversion

An indicator that eliminates losses is every bit as important – if not more important – than one that increases wins. A good volume indicator is one such indicator and it is worth as long as it takes to find a good one. Combine it with a good exit indicator and you’re not just eliminating bad trades, you’re also reducing your losses. That is a force multiplier for your wins.

Ultimately, even a bad volume indicator can, in many cases, save you from making losing trades. The trick is to balance that with making the trades you can win. That’s because a bad volume indicator – while it will certainly cut down your losses – will also prevent you from entering potentially lucrative winning trades. Nobody can tell you which indicator is going to work best with your system and you should immediately ignore anyone who tries. The only thing that will tell you which volume indicator to integrate into your process is to test, test, and then test some more. You have to put in the legwork.

You also have to remember that no indicator is perfect. You have to balance the losses it saves you from and the wins it prevents. A volume indicator that tells you to avoid ten trades that would have been losses and stops you from entering three trades that would have been winning is, on balance, going to save you a lot of money. Of course, it is on you to work out how big the losses would have been in comparison to the wins and to factor that in when choosing the right indicator. In the same way, as it is your job to figure out whether you can find a volume indicator that can save you ten losses and only stop you from entering one winning trade.

But, with volume indicators (and with your approach to trading in general), eliminating losses is the path to success. Put the work in to find a good volume indicator, test it to the max and make sure it works how you need it to. Trade with confidence when it gives you a green light and, when it doesn’t, put your cards down on the table like a boss and stay out of the trade.

Which Indicator?

As we said, nobody can tell you which indicator is going to work best with your system. You will have to put the work in and figure that out on your own. However, here are some indicators to take a look at and one to avoid.

Average Volume: This is the most basic, run-of-the-mill indicator that’s already integrated into your platform. It’s a moving day average set to a specific number of days and if you’re tracking a moving price average, it makes sense to set the average volume indicator to the same number of days. Bear in mind that anything less than 50 days is going to throw up a lot of unnecessary noise.

Force Index: This measures how bearish or bullish the market is at a given moment. You can use this in conjunction with a moving price average to measure how significant changes are in the power of bullish or bearish sentiment. It won’t do the job of telling you when to avoid a trade so much as it will tell you how robust a price trend is.

Volume Oscillator: This is a combination of two moving averages, one fast and one slow (with the fast one subtracted from the slow one). It can show you how strong a prevailing price trend is by tracking when a price movement is followed by an increase in volume. When the indicator is above the zero line, this may be a sign that the prevailing trend has some wind in its sails. Conversely, a change in price followed by a slump in volume is a good sign that the trend is lacking strength.

On-Balance Volume: Just like the Volume Oscillator, this indicator is trying to show you whether a price movement is backed by an increase in volume. It does this by combining price and volume. On an up day, the volume is added to the previous day’s score and on a down day, it is subtracted. Again, this will give you an indication of the strength of conviction behind a given price movement.

Accumulation/Distribution: The A/D line seeks to confirm price trends or highlight weak movements. Volume is accumulated when the day’s close is higher than the previous days close and distributed when the day’s close is lower than that of the previous day. The main way you use this indicator is to detect whether there is a divergence between price movement and volume movement.

Average True Range: Volatility is, as you now know, very closely related to volume and, as a result, you might be able to use some volatility indicators in place of a volume indicator. One advantage of doing this is that volatility indicators can be easier to read and some people chose to use the Average True Range (ATR) as a stand-in for a volume indicator. There are several problems with doing this, however, and here are just a couple of them. For one thing, it can be nearly impossible to figure out where to place the cut-off line – the line below which you will listen to your indicator and pull out of a trade.

Firstly, that line will have change and adapt as markets change, which means you will constantly be lowering or raising it. Secondly, you will also need to have a separate cut-off for each currency pair you trade. Thirdly, you will have to raise or lower the line for each currency pair as market conditions change over time. And, as if all of that weren’t enough, you will have a hard time backtesting it because of this inconsistency over time and across currencies. A good volume indicator should be consistent over time and reflect the market in most, if not all, conditions.