4 Types of Forex (FX) Trend Indicators

Many forex traders spend their time looking for a perfect moment to enter a trade or a telltale sign that screams "buy" or "sell." While the search can be fascinating, the results are hardly ever conclusive. The truth is, there is no foolproof way to trade the forex markets. As a result, traders must learn that there are a variety of indicators that can help to determine the best time to buy or sell a forex cross rate.

Here are four market indicators many successful forex traders rely upon.

Indicator No.1: A Trend-Following Tool

It is possible to make money using a countertrend approach to trading. However, for most traders, it’s easier to recognize the direction of a major trend and attempt to profit by trading in the trend's direction. This is where trend-following tools come into play.

Some people try to use them as a standalone trading system. While this is possible, the real purpose of a trend-following tool is to hint whether you should be pursuing a long position or a short position. Let's consider one of the simplest trend-following methods—the moving average crossover.

A simple moving average represents the average closing price over a certain number of days. To elaborate, let's look at two simple examples—one longer term, one shorter term.

The chart directly below displays the euro/yen (EURJPY) cross with 50-period and 200-period moving averages. The theory suggests that the trend is favorable when the 50-period moving average (yellow line) is above the 200-period average (blue line), and unfavorable when the 50-period is below the 200-period. This example shows that the 50-period moving average crossing below the 200-period moving average on July 23, 2024 did a good job of identifying a sustainable downtrend of the market.

The chart below shows a different combination—the 10-period/30-period crossover. The advantage of this combination is that it will react more quickly to changes in price trends than in the previous example. On the downside, though, it will also be more susceptible to whipsaws than the longer-term 50-period/200-period crossover.

Many investors will proclaim a particular combination to be the best, but the reality is, there is no "best" moving average combination. In the end, forex traders will benefit most by deciding what combination (or combinations) fits best with their own trading strategies. From there, the trend—as shown by these indicators—can be used to tell traders if they should pursue a long or a short trade; it should not be solely relied on to time entries and exits.

Indicator No.2: A Trend-Confirmation Tool

A trend-following tool can tell us whether the major trend of a given currency pair is up or down. But how reliable is that indicator? As mentioned earlier, trend-following tools are prone to being whipsawed. It would help to have a way to gauge whether the current trend-following indicator is correct or not.

For this, we will employ a trend-confirmation tool. Much like a trend-following tool, a trend-confirmation tool may or may not be intended to generate specific buy and sell signals. Instead, we are looking to see if the trend-following tool and the trend-confirmation tool agree.

In essence, if both the trend-following tool and the trend-confirmation tool are bullish, then a trader can more confidently consider taking a long trade in the currency pair in question. Likewise, if both are bearish, then the trader can focus on finding an opportunity to sell short.

One of the most popular—and useful—trend confirmation tools is the moving average convergence divergence (MACD). This indicator first measures the difference between two exponentially smoothed moving averages. This difference is then smoothed and compared to a moving average of its own.

When the current smoothed average is above its own moving average, then the histogram at the bottom of the chart below is positive and an uptrend is confirmed. On the flip side, when the current smoothed average is below its moving average, then the histogram at the bottom of the figure below is negative and a downtrend is confirmed.

In essence, when the trend-following moving average combination is bearish (short-term average below long-term average) and the MACD histogram is negative, then we have a confirmed downtrend. When both are positive, we have a confirmed uptrend.

At the bottom of the chart below, we see another trend-confirmation tool that might be considered in addition to (or in place of) MACD. It is the rate of change indicator (ROC). As displayed in the chart below, the orange-colored line measures today's closing price divided by the closing price 28 trading days ago.

Readings above 1.00 indicate that the price is higher today than it was 28 days ago and vice versa. The blue line represents a 28-day moving average of the daily ROC readings. If the red line is above the blue line, then the ROC is confirming an uptrend. If the red line is below the blue line, then we have a confirmed downtrend.

Note below that the sharp price declines experienced by the euro/yen cross from mid-January to mid-February, late April through May and during the second half of August were each accompanied by:

• The 50-day moving average below the 200-day moving average
• A negative MACD histogram

A bearish configuration for the ROC indicator (red line below blue):

Indicator No. 3: An Overbought/Oversold Tool

After opting to follow the direction of the major trend stage, a trader must decide whether they are more comfortable jumping in as soon as a clear trend is established or after a pullback occurs. In other words, if the trend is determined to be bullish, the choice becomes whether to buy into strength or buy into weakness.

If you decide to get in as quickly as possible, you can consider entering a trade as soon as an uptrend or downtrend is confirmed. On the other hand, you could wait for a pullback within the larger overall primary trend in the hope that this offers a lower risk opportunity. For this, a trader may rely on one of the overbought/oversold indicators.

There are many indicators that can fit this bill. However, one that is useful from a trading standpoint is the three-day relative strength index, or three-day RSI for short. This indicator calculates the cumulative sum of up days and down days over the window period and calculates a value that can range from zero to 100. If all of the price action is to the upside, the indicator will approach 100; if all of the price action is to the downside, then the indicator will approach zero. A reading of 50 is considered neutral.

The chart below displays the three-day RSI for the euro/yen cross. Generally speaking, a trader looking to enter on pullbacks would consider going long if the 50-day moving average is above the 200-day and the three-day RSI drops below a certain trigger level, such as 20, which would indicate an oversold position.

Conversely, the trader might consider entering a short position if the 50-day is below the 200-day and the three-day RSI rises above a certain level, such as 80, which would indicate an overbought position. Different traders may prefer using different trigger levels.

Different traders will have their own trigger levels.

Indicator No.4: A Profit-Taking Tool

The last type of indicator that a forex trader needs is something to help determine when to take a profit on a winning trade. Here, too, there are many choices available. In fact, the three-day RSI can also fit into this category. In other words, a trader holding a long position might consider taking some profits if the three-day RSI rises to a high level of 80 or more.

Conversely, a trader holding a short position might consider taking some profit if the three-day RSI declines to a low level, such as 20 or less.

Another useful profit-taking tool is a popular indicator known as Bollinger Bands. This tool takes the standard deviation of price-data changes over a period, and then adds and subtracts it from the average closing price over that same time frame, to create trading "bands." While many traders attempt to use Bollinger Bands to time the entry of trades, they may be even more useful as a profit-taking tool.

The chart below displays the euro/yen cross with 20-day Bollinger Bands overlaying the daily price data. A trader holding a long position might consider taking some profits if the price reaches the upper band, and a trader holding a short position might consider taking some profits if the price reaches the lower band.

A final profit-taking tool would be a "trailing stop." Trailing stops are typically used as a method to give a trade the potential to let profits run, while also attempting to avoid losing any accumulated profit. There are many ways to arrive at a trailing stop. The chart below illustrates just one of these ways.

The trade shown below assumes that a short trade was entered in the forex market for the euro/yen. Each day the average true range over the past three trading days is multiplied by five and used to calculate a trailing stop price that can only move sideways or lower (for a short trade), or sideways or higher (for a long trade).

The Bottom Line

If you are hesitant to get into the forex market and are waiting for an obvious entry point, you may find yourself sitting on the sidelines for a long while. By learning a variety of forex indicators, you can determine suitable strategies for choosing profitable times to back a given currency pair. As you gain confidence, you'll be able to determine pairs of indicators that will help pinpoint trade opportunities.

Also, continued monitoring of these indicators will give strong signals that can point you toward a buy or sell signal. As with any investment, strong analysis will minimize potential risks.