NoaFX Tutorial

5.1 What are Technical Indicators?

Technical indicators are visual representations of the nature of price change behaviour of a currency pair.

Each indicator has its own formula and context of study, which hopes to study that certain price behaviour and have it reflected in a visually understandable manner.

Though all of the indicators study the price action, their objective is to derive various different inference points from these actions and provide a possible indication of where the price could be heading next.

Most indicators are used to predict what can happen next based on;

  • The visual interpretation of the indications given by the indicator.
  • Strong/Weak hold levels that are stressed or broken which indicate possible immediate price action.
  • Past historical behaviour with current indication, which can be reflective of what could happen in the immediate future with reference to the similar past event.
Why are Technical Indicators important?
  • Clarity of Vision

Often with raw price action and data, it can be visually challenging, misleading or even impossible to interpret where the price could be heading next. Therefore, with indicators, often with clear and pleasant visuals, these challenges can be overcome.

  • Because I see what the market sees, it works?

Assuming there is an indicator which says sell. Assuming that 99% of the market uses this indicator and they only trade by that indicator, given no other external factors can influence this decision.

Now because everyone is following this indicator and because everyone sells, will that particular price action be influenced to have a downwards trend? Possibly. Did the market move because the indicator says Sell? No. The market moved because everyone believed that since this indicator said sell and everyone knows that everyone else is following this indication, there was a concerted belief which became an action and the market indeed trended downwards.

This is called a self-fulfilling prophecy. Where because one believed as such and the actions followed because of the belief system, the belief is now true.

The Shortcomings of Indicators
  • Time to reflect – The Lag Factor

    All indicators, regardless of how complex or superior they are, they can only reflect what has happened. In other words, their calculations and understandings are derived from feedback from the market, based on price action.

    Therefore, they are always reporting what has happened. The "faster" the indicator, the more "responsive" its indications are towards the price changes. The "slower" the indicator, lesser the "responsiveness" its indications are towards the price changes. As you can notice, the factor is how "Fast" or "slow" the indicator can be. In other words, it is a parameter of how much of lag or latency, can the indicator have between the price action and the point of it being shown on the charts.

  • Many indicators, many more still!

    There are countless indicators already developed and there are new ones being developed every single day. Though they are all attempting to predict the same objective; future price action, they are all assuming different price studies and presenting future behaviour with these assumptions made.

    Often, there are classic cases of traders having multiple indicators on their charts bearing the same information!

  • Painting and Re-Painting.

    Most indicators re-paint or re-draw themselves after the charts have been re-loaded. During a dynamic situation, where decisions have to be made upon the price action happening, these indicators do not reflect realtime, reflective of the price action.

    However, when the charts are re-loaded or the indicators are re-drawn on the charts, the indicators suddenly signal a possible trade setup, which wasn't there earlier. This can lead to assumptions that our eyes are playing tricks with us and can lead to an emotional or stressful experience.
Types of Indicators

Here are the various indicators under their various indicator group settings within the MT4 platform;

Volumes

  • Accumulation/Distribution
  • Money Flow Index
  • On Balance Volume
  • Price and Volume Trend
  • Volume Rate of Change

Oscillators

  • Average True Range
  • Chaikin Oscillator
  • Chaikin Volatility
  • DeMarker
  • Detrended Price Oscillator
  • Elder-Rays
  • Envelopes
  • Force Index
  • Ichimoku Kinko Hyo
  • Momentum
  • Moving Average Convergence/Divergence
  • Moving Average of Oscillator
  • Price Rate of Change
  • Relative Strength Index
  • Relative Vigor Index
  • Stochastic Oscillator
  • Ultimate Oscillator
  • Williams` Percent Range

Trends Indicators

  • Average Directional Movement Index
  • Accumulation Swing Index
  • Bollinger Bands
  • Commodity Channel Index
  • Mass Index
  • Moving Average
  • Pivot Points Support and Resistance Lines
  • Parabolic SAR
  • Standard Deviation
  • ZigZag
  • Williams` Accumulation/Distribution

Bill Williams

  • Acceleration/Deceleration
  • Alligator
  • Awesome Oscillator
  • Fractals
  • Gator Oscillator
  • Market Facilitation Index
The Moving Average Indicator

This section is dedicated to the Moving Average indicator, or commonly called as MAs (Moving Averages).

This indicator is probably the most simplest and most basic of indicators, its usage and application has to be emphasized. The Moving Average is often a component or is an underlying indicator with many other indicators.

Therefore, it is important to understand its concept, usage behaviour and application to appreciate its ability and also build on our understanding of this indicator and all other indicators that may use this indicator.

What is the Moving Average Indicator?

A Moving Average indicator quite simply calculates the difference between the prices and notices the change as a variable. This variable is then displayed on the charts as a price pattern.

Observations of the Moving Average indicator;

  • Notice how the price action is smoothed out by following the moving average trend direction.
  • In an uptrend, the price action (candles drawn) will always be "above" the moving average. Whereas in a downtrend, the price action (candles drawn) will be below the moving average.
What are Moving Averages made up of?

Moving Averages calculate (usually) the change of price over time.

The Simple Moving Average

To understand the concept of how Moving Averages are built, let us consider the most basic type of Moving Average, the Simple Moving Average or SMA.

A simple moving average is formed by computing the average (mean) price of a currency pair over a specified number of periods;

For example: A 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.

10+ 11 + 12 + 13 + 14 = 60

(60 / 5) = 12

While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price.

Therefore, if the average price is 12 and the current price of the currency pair is 15, it is perceived to be of a higher value than its average price and therefore continued further price appreciation is possible.

The Exponential Moving Average

The Exponential Moving Average(EMA) computes price change just the same way that the SMA does, but provides weightage to the most recent price change, in an attempt to reduce the "lag" factor within the price change indications;

The formula for an exponential moving average is:

EMA (current) = ( (Price(current) - EMA(prev) ) x Multiplier) + EMA(prev)

It is therefore much more difficult to do the math to calculate the EMA when compared to the SMA. However, an EMA is highly preferred to reflect volatile market conditions more closely as it is more responsive than the SMA.

The Linear Weighted Moving Average

The Linear Weighted Moving Average (LWMA) is the least common out of the three and is used to address the problem of the equal weighting. The linear weighted moving average is calculated by taking the sum of all the closing prices over a certain time period and multiplying them by the position of the closing price and then dividing by the sum of the number of periods.

For example, in a five-day linear weighted average, today's closing price is multiplied by five, yesterday's by four and so on until the first day in the period range is reached. These numbers are then added together and divided by the sum of the multipliers.

LWMA = (Price Today + Number of Periods) x (Price Yesterday + Number of Periods-1) X (…)

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Number of Periods

The Smoothed Moving Average

The Smoothed Moving Average (SMMA) is the least important and the most underused moving average of all of the above versions.

The SMMA is a hybrid between the SMA and the EMA. It gives a weighted application to all the various periods but also averages them out over the various periods. The difference is that they are linearly weighted such that the oldest data doesn't impact the result that severely, but is not removed from the equation unlike the SMA. Therefore, the SMMA usually takes a longer period of study.

Lets see how a Smoothed Moving Average is calculated:

The first value for a Smoothed Moving Average is calculated as a Simple Moving Average (SMA):

SUM1 = SUM( CLOSE, N)

SMMA1 = SUM1/N

The second and succeeding moving averages are calculated according to this formula:

SMMA (i) = (SUM1-SMMA1+CLOSE(i))/N

Where:
SUM1 — is the total sum of closing prices for N periods;
SMMA1 — is the smoothed moving average of the first bar;
SMMA (i) — is the smoothed moving average of the current bar (except for the first one);
CLOSE (i) — is the current closing price;
N — is the smoothing period.

For the following example we will set the PERIOD equal to 3. We will assume the price of each day is the same as the day number for the price, thus, price 1 = 1, price 2 = 2, and so on.

In this case, for the first data point, it will be the same as a Simple Moving Price calculation. It is plotted on the chart at the third bar from the first bar used in the calculation.

SMMA = (PRICE 1 + PRICE 2 + PRICE 3)/PERIOD

SMMA = (1 + 2 + 3) / 3

= 6 / 3

= 2

The next value would be plotted at the fourth bar from the first bar used in the calculation.

SMMA = (PREVIOUS SUM - PREVIOUS AVG + PRICE 4) / PERIOD

For the second calculation of SMMA, PREVIOUS SUM is the sum of PRICE 1 + PRICE 2 + PRICE 3; and PREVIOUS AVG is the initial value of SMMA.

SMMA = (6 - 2 + 4) / 3

= 8 / 3

= 2.67

The next value would be plotted at the fifth bar from the first bar used in the calculation.

SMMA = (PREVIOUS SUM - PREVIOUS AVG + PRICE 5) / PERIOD

For the third and subsequent calculations of SMMA, values would be determined by subtracting the PREVIOUS AVG from the PREVIOUS SUM, adding the next more recent PRICE, and then dividing by the PERIOD.

SMMA = (8 - 2.67 + 5) / 3

= 10.33 / 3

= 3.44

SMMA = (10.33 - 3.44 + 6) / 3

= 12.89 / 3

= 4.30

This process can be repeated for subsequent calculations.

Application of the Various Moving Averages

As we can infer from the chart, the most responsive EMA, closest to price action and fastest to show trend changes, is the Smoothed Moving Average, SMMA.

Application of Moving Averages
  • In signaling an uptrend, the price range will always be above the moving average indicator.
  • In signaling a downtrend, the price range will always be below the moving average indicator.

Therefore, used in its simplicity, moving averages signal trend changes and can be used to trade currency pairs in a trend chasing strategy.


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