# Forex Technical Indicators – Part 1

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# Forex Technical Indicators

## Indicator Interpretation

An indicator is a mathematical calculation that can be applied to a security’s price and/or volume fields.  The result is a value that is used to anticipate future changes in prices.

MetaStock for Java includes many of the most popular indicators used among technical analysts.  All of the indicators are calculated using only one or two values, either the closing price, the volume, or both.

A moving average fits this definition of an indicator: it is a calculation that can be performed on a security’s price to yield a value that can be used to anticipate future changes in prices.

MetaStock for Java also allows you to draw support/resistance lines and trendlines.  Support/resistance and trendline analysis lie at the heart of technical analysis, since they are based on basic laws of supply and demand.

### Accumulation/Distribution

Overview
The Accumulation/Distribution is a momentum indicator that associates changes in price and volume.  The indicator is based on the premise that the more volume that accompanies a price move, the more significant the price move.

Interpretation
The Accumulation/Distribution is really a variation of the more popular On Balance Volume indicator.  Both of these indicators attempt to confirm changes in prices by comparing the volume associated with prices.

When the Accumulation/Distribution moves up, it shows that the security is being accumulated as most of the volume is associated with upward price movement.  When the indicator moves down, it shows that the security is being distributed as most of the volume is associated with downward price movement.

Divergences between the Accumulation/Distribution and the security’s price imply a change is imminent.  When a divergence does occur, prices usually change to confirm the Accumulation/Distribution.  For example, if the indicator is moving up and the security’s price is going down, prices will probably reverse.

### Bollinger Bands

Overview
Bollinger Bands are similar to moving average envelopes. The difference between Bollinger Bands and envelopes is envelopes are plotted at a fixed percentage above and below a moving average, whereas Bollinger Bands are plotted at standard deviation levels  above and below a moving average.  Since standard deviation is a measure of volatility, the bands are self-adjusting: widening during volatile markets and contracting during calmer periods.

Bollinger Bands were created by John Bollinger.

Interpretation
Bollinger Bands are usually displayed on top of security prices, but they can be displayed on an indicator.  These comments refer to bands displayed on prices.

As with moving average envelopes, the basic interpretation of Bollinger Bands is that prices tend to stay within the upper- and lower-band.  The distinctive characteristic of Bollinger Bands is that the spacing between the bands varies based on the volatility of the prices.  During periods of extreme price changes (i.e., high volatility), the bands widen to become more forgiving.  During periods of stagnant pricing (i.e., low volatility), the bands narrow to contain prices.

Mr. Bollinger notes the following characteristics of 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 observation is useful when projecting price targets.

### CCI

Overview
The Commodity Channel Index (CCI) is calculated by first determining the difference between the mean price of a commodity and the average of the means over the time period chosen. This difference is then compared to the average difference over the time period (this factors in the commodity’s own inherent volatility). The result is then multiplied by a constant that is designed to adjust the CCI so that it fits into a “normal” trading range of +/-100.

Interpretation
While the CCI was originally designed for commodities, the indicator also works very well with stocks and mutual funds.

There are two methods of interpreting the CCI:

Looking for divergences

A popular method of analyzing the CCI is to look for divergences in which the underlying security is making new highs (lows) while the CCI is failing to surpass its previous highs (lows). This classic divergence is usually followed by a correction in the security’s price.

As an overbought/oversold indicator

The CCI usually oscillates between +/-100. Readings above +100 imply an overbought condition and the liklihood of a downward move has increased. Readings below -100 imply an oversold condition and the liklihood of an upward move has increased

Envelope

Overview
An envelope is comprised of two moving averages.  One moving average is shifted upward and the second moving average is shifted downward.

Interpretation
Envelopes define the upper and lower boundaries of a security’s normal trading range.  A sell signal is generated when the security reaches the upper band whereas a buy signal is generated at the lower band. The optimum percentage shift depends on the volatility of the security–the more volatile, the larger the percentage.

The logic behind envelopes is that overzealous buyers and sellers push the price to the extremes (i.e., the upper and lower bands), at which point the prices often stabilize by moving to more realistic levels.  This is similar to the interpretation of Bollinger Bands.

### MACD

Overview
The MACD (“Moving Average Convergence/Divergence”) is a trend following momentum indicator that shows the relationship between two moving averages of prices.  The MACD was developed by Gerald Appel, publisher of Systems and Forecasts.

The MACD is the difference between a 26-day and 12-day exponential moving average.  A 9-day exponential moving average, called the “signal” (or “trigger”) line is plotted on top of the MACD to show buy/sell opportunities.  (Appel specifies exponential moving averages as percentages as explained on page 170.  Thus, he refers to these three moving averages as 7.5%, 15%, and 20% respectively.)

Interpretation
The MACD proves most effective in wide-swinging trading markets.  There are three popular ways to use the MACD: crossovers, overbought/oversold, and divergences.

Crossovers.

The basic MACD trading rule is to sell when the MACD falls below its signal line.  Similarly, a buy signal occurs when the MACD rises above its signal line.  It is also popular to buy/sell when the MACD goes above/below zero.

Overbought/Oversold Conditions.

The MACD is also useful as an overbought/oversold indicator.  When the shorter moving average pulls away dramatically from the longer moving average (i.e., the MACD rises), it is likely that the security price is overextending and will soon return to more realistic levels. MACD overbought and oversold conditions exist vary from security to security.

Divergences.

A indication that an end to the current trend may be near occurs when the MACD diverges from the security (page 32). A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows.  A bullish divergence occurs when the MACD is making new highs while prices fail to reach new highs.  Both of these divergences are most significant when they occur at relatively overbought/oversold levels.

### Momentum

Overview
The Momentum indicator measures the amount that a security’s price has changed over a given time span.

Interpretation
The interpretation of the Momentum indicator is identical to the interpretation of the Price ROC.  Both indicators display the rate-of-change of a security’s price.  However, the Price ROC indicator displays the rate-of-change as a percentage whereas the Momentum indicator displays the rate-of-change as a ratio.

There are two ways to use the Momentum indicator:

• You can use the Momentum indicator as a trend-following oscillator similar to the MACD (this is the method I prefer).  Buy when the indicator bottoms and turns up and sell when the indicator peaks and turns down.  You may want to plot a short-term (e.g., 9-period) moving average of the indicator to determine when it is bottoming or peaking.

If the Momentum indicator reaches extremely high or low values (relative to its historical values), you should assume a continuation of the current trend.  For example, if the Momentum indicator reaches extremely high values and then turns down, you should assume prices will probably go still higher.  In either case, only trade after prices confirm the signal generated by the indicator (e.g., if prices peak and turn down, wait for prices to begin to fall before selling).

• You can also use the Momentum indicator as a leading indicator.  This method assumes that market tops are typically identified by a rapid price increase (when everyone expects prices to go higher) and that market bottoms typically end with rapid price declines (when everyone wants to get out).  This is often the case, but it is also a broad generalization.

As a market peaks, the Momentum indicator will climb sharply and then fall off–diverging from the continued upward or sideways movement of the price.  Similarly, at a market bottom, Momentum will drop sharply and then begin to climb well ahead of prices.  Both of these situations result in divergences between the indicator and prices.

### Moving Average

Overview
A Moving Average is an indicator that shows the average value of a security’s price over a period of time.  When calculating a moving average, a mathematical analysis of the security’s average value over a predetermined time period is made.  As the security’s price changes, its average price moves up or down.

There are several popular ways to calcuate a moving average.  MetaStock for Java calculates a “simple” moving average–meaning that equal weight is given to each price over the calculation period.

Interpretation
The most popular method of interpreting a moving average is to compare the relationship between a moving average of the security’s price with the security’s price itself.  A buy signal is generated when the security’s price rises above its moving average and a sell signal is generated when the security’s price falls below its moving average.

This type of moving average trading system is not intended to get you in at the exact bottom nor out at the exact top.  Rather, it is designed to keep you in line with the security’s price trend by buying shortly after the security’s price bottoms and selling shortly after it tops.

The critical element in a moving average is the number of time periods used in calculating the average.  When using hindsight, you can always find a moving average that would have been profitable.  The key is to find a moving average that will be consistently profitable.  The most popular moving average is the 39-week (or 200-day) moving average.  This moving average has an excellent track record in timing the major (long-term) market cycles.

### Moving Average Crossover

Overview
A Moving Average is an indicator that shows the average value of a security’s price over a period of time.  When calculating a moving average, a mathematical analysis of the security’s average value over a predetermined time period is made.  As the security’s price changes, its average price moves up or down.  See the Moving Average page for more information on moving averages.

The Moving Average Crossover indicator prompts you for two parameters.  A shorter moving average and a longer moving average.

Interpretation
The most popular method of interpreting a single moving average is to compare the relationship between a moving average of the security’s price with the security’s price itself.  However, you can also compare the relationship between a shorter-term moving average and a longer-term moving average.  For example, by entering 9 in the first box,  and 39 in the second box, MetaStock for Java will plot both moving averages on the price chart.  Look for possible buying opportunities when the shorter moving average crosses above the longer moving average.  Conversely, look for possible selling opportunities when the shorter moving average crosses below the longer moving average.

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