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Getting Started in Currency Trading, by Michael Archer and Jim Bickford

December 30th, 2008

Page 101 – Indicators and Oscillators

There are various market indicators  that can be charted or graphed that provide buy or sell signals.

Relative Strength Indicator (RSI)
The relative strength indicator shows whether the currency is overbought or oversold.  Overbought indicates an an upward trend since traders are buying a currency in hope of a further rate increase.  When most traders get lured into long positions, oversaturation occurs, the traders show restraint in making additional purchases and begin to take profits.  The profit taking or lack of new buying can lead to a trend down, or at least a short term downward consolidation.

Oversold indicates the market is showing a downward trend since traders are selling a currency in hope that its rate falls.  Again, saturation occurs when traders are in short positions or when there are no sellers left.  When short covering occurs, or the selling stops, the market rebound upwards sharply.

The RSI is a numerical indicator of price fluctuations over a given time period.  It is expressed as a percentage.

RSI = sum of price rises / sum of all price fluctuations

An RSI between 30 and 70 percent is considered neutral.  Below 25 percent indicates an oversold market, over 75 percent indicates an overbought market. The RSI should never be considered alone though and should always be considered in conjunction with other indicators and charts.

Moving Averages (MA)
The MA is another indicator used to determine the tends and general market entry and exit signals.  It is the arithmetic average of closing prices over a given period.  The longer the period studied, the weaker the magnitude of the moving average curve. The number of closes in the given period is called the moving average index.

Market signals are generated by calculating the residual value:

Residual Value = Price(X) – MA(X)

When the residual value crosses into the positive area, this is a bullish signal and a buy signal is generated.  When the residual value crosses below zero, this is a bearish signal and a sell signal is generated.

A refinement of the MA residual method is the is the use of two moving averages.  This is called the moving average convergence divergence, or MACD for short.  When the MA withthe shorter MA index (called the oscillating MA index) crosses above the MA with the longer MA index (called the basis MA index), a sell signal is generated.

MACD Residual Value = Basis MA(X) – Oscillating MA(X)

The usefulness of the moving average residual method depends heavily on the MA indices chosen. Be sure to use this indicator in conjunction with other indicators.

Bollinger Bands
The technique involves overlaying three bands on top of a bar chart of the currency.  The central band is the simple arithmetic moving average of the daily closes.  The upper and lower bands are the standard deviation above and below the central moving average. The inputs are the number of days in the moving average index and the number of standard deviations to plot above and below the moving average. Typical values for the standard deviation are between 1.5 and 2.5 standard deviations. Bollinger recommends 10 days for short-term trading, 20 days for intermediate term trading, and 50 days for longer-term trading.

Bollinger notes the following signals from Bollinger bands:

  • Sharp price changes tend to occur after the bands tighten, as volatility lessens
  • When prices move outside the bands, a continuation of the current trend is implied
  • Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend
  • A move that originates at one band tends to go all the way to the other band – this is useful when projecting price targets
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