Indicators part I The Trend Followers

An indicator, also called a study, is a tool used to analyze price movements. Indicators usually fall into two main groups: trend-following and oscillating indicators. Trend-following indicators are most useful when the price is trending in one direction or the other. Oscillating indicators are useful when a price is consolidating into a range. It is important to know which group the indicator you are using falls into, and to choose the correct indicator for every scenario.

Here are some common trend-following indicators:

ADX

ADX or Average Directional Index is a special type of trend-following indicator that can help a Forex trader decide whether a trend follower is, in fact, the best tool for the job at that particular moment. Trend-following indicators will function best when the ADX is over 30. When it is below 30, then an oscillating indicator may be a better choice.

When the ADX is rising, this indicates that the trend is gaining in strength. When it begins to decline, it is a sign that the trend is losing steam and a trading range may soon develop. Likewise, when the ADX begins rising again it indicates that the price is breaking out of its range and a new trend may emerge. However, the ADX only indicates the strength of the trend and does not show the direction in which it is going (up or down).

In the example below, note how the ADX starts off low as the price is trading within a range near the left side of the chart. Then, as the price starts to drop, the ADX rises above 30 to indicate a trend in progress. The ADX also confirms that the trend is over by beginning to decline once again. Then when it finally drops below 30, we find ourselves trading once again in a tight range.

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MACD

MACD or Moving Average Convergence Divergence measures the difference between a short-term and longer-term moving average. When the red line crosses above the blue line, it indicates an uptrend and when the red crosses below the blue line, it indicates a downtrend.

Additionally, the green bars (called the MACD histogram) give us an indication of the trend’s strength or weakness. Unlike the ADX, they also show us the overall direction of the trend. Longer bars indicate increasing strength and shorter bars indicate decreasing strength.

In the following example, we can see that the red MACD line falls below the blue one as the price begins its move downward. The green bars in the histogram are increasing in length as well, indicating that the downtrend is gaining momentum. When price reverses to move up, the histogram reflects a loss of downward strength. Downward strength resumes as the next long red candle posts on the chart. However, it is important to note that while the price made a lower low, the histogram did not make it quite as far down. This is known as a bullish divergence and indicates that the trend will soon end and be followed by a reversal.

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Linear Regression

Linear regression is a special kind of moving average that is more responsive to price changes and with less delay. When a price makes an extreme move away from its linear regression line (the red line in the chart below), a quick counter-trend trade can sometimes be taken as the price snaps back to “normal” – with the same linear regression line also acting as the target for taking profits.

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Next Article: Indicators Part II, The Oscillators

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