There are two main schools of though in the financial markets – technical analysis and fundamental analysis. Technical analysis is the study of market price action in an attempt to predict future prices; fundamental analysis is the study of the news and other economic data in order to achieve the same result. Technical analysts generally believe that all the known information is already included in the market's price and that there is no way of predicting how the market will react to new information as it is released.
Within technical analysis there are two main groups, chartists and technicians. Chartists study the raw price charts only, seeing all technical indicators as merely unhelpful distorted representations of the price. Technicians however, whilst acknowledging that their technical indicators are just price representations, see them as helpful tools to allow one to make sense of the price movement. I believe that all technical indicators are just distorted representations of market's price; but I believe these distortions can be useful as they allow the human brain to process the significance of the price movements easier than a raw price chart might (which itself is just a graphical representation of the data anyway).
Almost all trading indicators are technical indicators, there are some notable exceptions such as indicators based on the data derived from sources like the Commitments of Traders report and other market sentiment indexes; but in this article I will only be talking about technical indicators. All technical indictors are representations of the market's price and measure the price's direction and/or the price's momentum (its rate of change). Indicators that measure price direction are lagging indicators that detect trends after they have occurred. Indictors that measure the rate of the price change (momentum indicators) are usually used to measure the likely hood of a price reversal or to measure the strength of the trend that's in place.
There are literally hundreds, if not thousands, of technical trading indicators out there, but they all measure the same thing; the market's price - the price's direction and it's rate of change. So in this article I only want to write about a few of the most common (and in my opinion) the best indictors.
Moving Averages,
In technical analysis, moving averages are used to smooth out short-term price fluctuations and show the direction of the trend; moving averages are amongst the oldest technical indicators and, in my opinion, one of the best. Moving averages are lagging indicators that pay attention to price direction only; they reveal a trend after it has been in place for sometime. The two most common types of moving averages used in technical analysis are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). A Simple Moving Average is the average (or mean) value of a certain number of data points. For example, a 3-day SMA would be today's price + yesterday's price + the day before yesterdays price divided by 3. An Exponential Moving Average is similar to the Simple Moving Average, the only difference being that it applies a weighting factor (which decreases exponentially) to the data; for example, a 3-day EMA would still be composed of today's price, yesterday's price and the day before yesterdays price, but today's price would carry the most weight and the last day's price would carry the least. The formula used for calculating the EMA's weighting factor is 2/(EMA period+1). Moving averages are typically applied to the bar (or candles) closing values, however they can be applied to the bar's highs, lows, or anything else. The table below is an example of the values of a 5-day SMA and 5-day EMA applied to the closing price of the Cable market.
The Date
Closing Price
5 Day SMA
5 Day EMA
2009.06.05
15979.5
N/A
N/A
2009.06.08
16043.0
N/A
N/A
2009.06.09
16314.9
N/A
N/A
2009.06.10
16343.1
N/A
N/A
2009.06.11
16572.5
N/A
N/A
2009.06.12
16442.0
16433.0
16396.9
2009.06.15
16302.5
16400.6
16393.5
2009.06.16
16394.2
16432.4
16399.8
2009.06.17
16388.3
16387.5
16400.5
2009.06.18
16339.7
16360.7
16367.2
2009.06.19
16492.5
16427.8
16402.4
2009.06.22
16343.0
16423.8
16390.7
2009.06.23
16450.8
16418.0
16410.1
2009.06.24
16410.4
16436.3
16411.9
2009.06.25
16378.6
16384.0
16406.6
Moving averages don't predict future price movements; rather, they simply show what has already happened and reveal the trend's direction. Trading systems that use moving averages are usually trend following in nature. The idea behind these systems is usually to catch a trend after it has begun and ride it until it has finished. These systems only work well when the market is trending. In choppy sideways moving markets these systems usually result in a string of losses as any minor trend probably won't last long enough to make a big enough profit to make up for the pips that are given back when the trend reverses as the trend reversal will have to be well under way before the moving averages will detect it. One example of a mechanical trading system using moving averages might be to go long when the 21-day SMA crosses above the 55-day SMA and go short when it crosses below it. I tested this system without a stop losses on the EUR/USD, USD/JPY, GBP/USD, USD/CHF and USD/CAD currency pairs and got the following results -
EUR/USD between October 1999 and March 2009. 47 Trades: 20 winners, 27 losers. Average winner 477.5 pips, average loser –273.4 pips. Total winnings 9550.0 pips, total lost –7382.6 pips. Winnings to losses ratio 1.29 to 1.
USD/JPY between September 1999 and May 2009. 44 Trades: 21 winners, 23 losers. Average winner 418.3 pips, average loser –258.6 pips. Total winnings 8785.1 pips, total lost –5948.0 pips. Winnings to losses ratio 1.48 to 1.
GBP/USD between November 1999 and April 2009. 51 Trades: 21 winners, 30 losers. Average winner 501.0 pips, average loser –271.0 pips. Total winnings 12201.0 pips, total lost –8131.0 pips. Winnings to losses ratio 1.50 to 1.
USD/CHF between October 1999 and April 2009. 42 Trades: 16 winners, 26 losers. Average winner 606.9 pips, average loser –340.5 pips. Total winnings 9711.0 pips, total lost –8853.1 pips. Winnings to losses ratio 1.10 to 1.
USD/CAD between November 1999 and July 2009. 48 Trades: 20 winners, 28 losers. Average winner 496.5 pips, average loser –204.3 pips. Total winnings 9930.8 pips, total lost –5721.0 pips. Winnings to losses ratio 1.74 to 1.
Below are two graphical examples of the 21/55-day moving average crossover on a daily candle stick chart -
An example of a 21/55-day SMA crossover system working well in a trending market
An example of a 21/55-day SMA crossover system working badly in a choppy sideways market
The Average Directional Index (ADX),
The Average Directional Index is one of my favourite technical indicators. It was invented in 1978 by J. Welles Wilder and measures the strength of the market's trend by comparing the number (and size) of the market's upward moves against the number and size of the market's downward moves. Most profitable trading systems make money by following the trend, so an indicator that tells us how strong the trend is can be a very useful tool indeed as the strength of the trend can indicate the probability of the trade's success.
The ADX is composed of an exponential moving average of two other indicators developed by Wilder; they are, the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). To calculate the Positive and Negative Directional Indicators (+DI and –DI), we need to know the Positive and Negative Directional Movements (+DM and –DM). The Positive Directional Movement is the number of points (or pips) the high of today went above yesterday's high by, and the Negative Directional Movement is the number of points (or pips) the low of today went below yesterday's low by. The greater of these two numbers is used providing they are positive – if both numbers are equal or the high and low both fail to surpass the previous day's extremes then the Directional Movements are set to zero.
In pseudo code: calculating the Directional Movements –
TheUpwardMovement = Today's High – Yesterday's High
TheDownwardMovement = Yesterday's Low – Today's Low
IF TheUpwardMovement > TheDownwardMovement AND TheUpwardMovement > 0 THEN
+DM = TheUpwardMovement
-DM = 0
ELSE
+DM = 0
END IF
IF TheDownwardMovement > TheUpwardMovement AND TheDownwardMovement > 0 THEN
-DM = TheDownwardMovement
+DM = 0
ELSE
-DM = 0
END IF
The Positive Directional Indicator (+DI) is an exponential moving average of the Positive Directional Movement (+DM) divided by the Average True Range, and the Negative Directional Indicator (-DI) is an exponential moving average of the Negative Directional Movement (-DM), also divided by the Average True Range. For a time period Wilder originally used 14 days for the exponential moving average, although other time periods (such as 15 and 20 days) are now common.
The ADX essentially measures the difference between the Positive and Negative Directional Indicators and displays it as a value between 0 and 100. The bigger the difference between the two indicators, the higher the ADX reading and the stronger the trend – it should be noted that the ADX does NOT tell us the trends direction, only it's strength. The ADX is calculated using an exponential moving average of the Positive Directional Indicator's value minus Negative Directional Indicator's value divided by the Positive Directional Indicator's value plus the Negative Directional Indicators value multiplied by one hundred.
In pseudo code: calculating the Average Directional Index –
+DI = EMA(+DM)
-DI = EMA(-DM)
ADX = EMA((+DI - -DI)/(+DI + -DI)) *100
An example of the Average Direction Index and the Directional Movement Indexes on a daily candlestick chart, +DI in Green, –DI in Red, ADX in Blue.
Using the ADX,
There are a number of different ideas on how the ADX should be used. The most common idea is that an ADX reading of 20 or less indicates a weak trend or choppy sideways market, and an ADX reading of greater than 20 but less than 40 indicates a moderate trend, and that a reading of 40 or greater signifies a strong trend. Other traders such as legendary commodity trader Chuck LeBeau argue that the ADX's absolute value is not as important as it's direction and argue that a steeply rising ADX at a low number is a better indicator that a trend is under way than a falling or flat ADX of a higher number. Personally I would tend to agree that the direction and the rate of change are more important than the absolute value. I'd certainly consider a change from 15 to 20 to be far more significant than a change from 25 to 26 in the same period of time. There is an excellent article about how to use the ADX on Chuck LeBeau's website with the title 'Direction is the Key to Using ADX Correctly'.
