An indicator is a formula run over past prices, and sometimes volume, then drawn on or under your chart. It can make a trend or a stretched move easier to see, but it cannot see anything price has not already done. Use each of the four below as a second opinion on a level or trend you have already marked.
What you will learn
- What moving averages, RSI, MACD and VWAP each measure, and their default settings
- Why every indicator lags, and roughly by how much
- How to pair one indicator with price without stacking several that say the same thing
Moving averages show direction and slope
A moving average is the average closing price over a set number of candles, recalculated each time a candle closes. It smooths out noise so you can see which way price is leaning.
A simple moving average (SMA) weights every candle equally. Five EUR/USD closes of 1.0850, 1.0862, 1.0871, 1.0858 and 1.0874 add up to 5.4315, and 5.4315 ÷ 5 = 1.0863, so that is the 5-period SMA.
An exponential moving average (EMA) gives more weight to recent candles. Its weighting factor is 2 ÷ (periods + 1), so a 20-period EMA puts about 9.5% (2 ÷ 21) on the latest close. If the 20 EMA was 1.0860 and the new close is 1.0900, the EMA moves 9.5% of that 40-pip gap, about 4 pips, to 1.0864.
Common settings are 20 for the short swing, 50 for the medium trend and 200 for the long trend. When the 50-day average crosses above the 200-day, traders call it a golden cross, and the opposite is a death cross. Both signals come late, because both averages are slow.
All that smoothing creates lag. A 20-period SMA is centred 9.5 candles in the past, so on a 1-hour chart it describes where price was roughly ten hours ago. An EMA reacts sooner and whipsaws more when the market goes sideways. Read the slope first: a rising average with price above it describes an uptrend, while a flat average with price weaving through it describes a range, where crossovers mean very little.
RSI measures how stretched a move is
The Relative Strength Index (RSI) compares the size of recent up-closes with recent down-closes and scales the answer from 0 to 100. J. Welles Wilder introduced it in 1978 with a 14-period default, and with 70 and 30 as the overbought and oversold lines.
RSI = 100 minus 100 ÷ (1 + RS), where RS is the average gain divided by the average loss over the period. If the average gain over 14 candles is 12 pips and the average loss is 6 pips, RS is 2, and RSI is 100 minus 100 ÷ 3, which is 66.7.
"Overbought" does not mean "about to fall". In a strong uptrend RSI can stay above 70 for days while price keeps climbing, and selling every reading above 70 would put you against the trend. As a rule of thumb, RSI tends to hold between about 40 and 80 in an uptrend and about 20 and 60 in a downtrend, so a dip to 40 that turns up often marks a pullback ending. A 7-period RSI hits the extremes far more often than the default 14, and a 21-period one rarely reaches them.
MACD tracks momentum from two averages
MACD (moving average convergence divergence) measures the gap between a fast EMA and a slow EMA. Gerald Appel developed it in the late 1970s, and the default settings are 12, 26 and 9.
The MACD line is the 12-period EMA minus the 26-period EMA. The signal line is a 9-period EMA of the MACD line, and the histogram is the MACD line minus the signal line.
Say the 12 EMA on EUR/USD is 1.0880 and the 26 EMA is 1.0860. The MACD line is 0.0020, or 20 pips, and because the fast average is above the slow one, recent momentum is up. With the signal line at 0.0015, the histogram reads 0.0005. A histogram that shrinks over several candles shows momentum fading while price is still rising, which is where the next lesson starts.
MACD lags more than either EMA alone, because it is built from averages and then averaged again. By the time the MACD line crosses the signal line, a good part of the move has often happened, so use MACD to judge whether momentum agrees with the trend and look to price for the entry.
VWAP marks the session's average price
VWAP (volume-weighted average price) is the average price paid during the session, weighted by how much traded at each price. It resets at the start of every session, which makes it a day-trading tool.
For each candle, take the typical price, (high + low + close) ÷ 3, and multiply it by that candle's volume. VWAP is the running total of those amounts divided by the running total of volume.
Take a share over its first three candles of the day:
- Candle one has a typical price of $100 on volume of 1,000, which gives 100,000.
- Candle two has $102 on 3,000, which gives 306,000.
- Candle three has $101 on 2,000, which gives 202,000.
That makes 608,000 ÷ 6,000 = $101.33. A plain average of the three prices would be $101.00, and VWAP sits higher because more volume traded at $102.
Day traders read price above VWAP as buyers in control of the session and price below it as sellers in control, and they watch how price reacts when it comes back to the line. Forex has no central exchange, so charting platforms build VWAP from tick volume (the number of price changes), which only stands in for traded volume. In the first hour of a session VWAP also rests on very few candles and moves around a lot.
Give one indicator one job
Mark the levels from support and resistance and the direction from trends and trendlines before you add anything. Then ask one indicator a specific question: a moving average answers "which way is the trend?", RSI or MACD answers "does momentum agree?", and VWAP answers "where is today's average price?".
RSI, MACD and the Stochastic oscillator all measure momentum from the same closing prices. When all three agree, you have one opinion counted three times.
Say EUR/USD on the 1-hour chart is trading above a rising 50 EMA. Price pulls back to 1.0850, an old resistance level that has turned into support and sits within 5 pips of the 50 EMA. RSI dips to 42 and turns up as a bullish candle closes at 1.0862. Price, the average and momentum point the same way, so this is a setup worth planning.
Now suppose RSI drops to 25 while price closes below 1.0850 and the 50 EMA flattens out. The low reading gives you no reason to buy, because price has broken the level and the trend read has changed.
Check your understanding
RSI on the daily chart has been above 70 for six days and price keeps making higher highs. Is that a sell signal?
No. A high RSI in a strong trend shows strong momentum and says nothing about when a reversal will come. You would want price to break its structure first.
On GBP/USD the 12 EMA is 1.2540 and the 26 EMA is 1.2555. What is the MACD line, and what does its sign tell you?
1.2540 minus 1.2555 is minus 0.0015, or minus 15 pips. The fast average is below the slow one, so recent momentum is down.
Key points
- Every indicator is a formula on past price, so all of them lag, and more smoothing means more lag.
- Moving averages show direction, RSI and MACD show momentum, and VWAP shows the session's volume-weighted average price.
- The defaults are 14 with 70 and 30 for RSI, 12, 26 and 9 for MACD, and 20, 50 and 200 for moving averages.
- Read price first, then give one indicator one job.
Next lesson: Spot when momentum stops agreeing with price
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