As traders that we are, or pretend to be, we will spend most of the time looking for the best time to enter the market in a certain direction. In this search, we will use some tools such as technical indicators. From my point of view, any trader who bases his trading on technical analysis should use at least 4 types of indicators.
Well, rather, you should use those indicators that respond to the 4 basic trading needs: recognize the prevailing trend -> confirm the trend -> find the best entry -> find the best exit. These needs can be covered with the information of 1 or several indicators. Thus, I will classify the indicators into 4 categories according to the need they will cover, although this classification is for illustrative purposes only.
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You can get more information about technical indicators in the following guide: Complete guide on technical indicators
Trend indicators
In our trading strategy, we need a tool that tells us what is the market trend. Although it is possible to earn money trading against the trend, most traders find easier to follow the trend than trade against it.
A trend indicator will tell us what is the direction of the main market trend so that we can try to get benefits by following its direction. From my point of view, a trend indicator, or trend following indicator, will help us know if we should look for buying opportunities or, on the contrary, look for sell opportunities. That is, these indicators serve to determine what kind of trades we should look for in the market but they will not determine when we can open
or close our positions. Some indicators can be used to generate entry signals but that depends on each trader since it is not the main objective of a trend indicator.
For example, the simplest trend indicator is the combination of moving averages, a slow one (a moving average with a longer period) and a fast-moving average (a moving average with a shorter period). When the fast moving average is above the slow moving average it will indicate a predominant uptrend and vice versa. The combination of moving averages that can be used depends on each trader since there is no single combination that works in all conditions and markets. In fact, in different trading systems, we can find different combinations of moving averages to analyze the trend. In other words, the best combination of moving averages is the one that best suits the time frame in which you trade as well as your objectives and trading style. That is, “the best combination of moving averages” does not exist.
Thus, using a trend indicator we will have the information on the predominant trend and we will know what attitude to have: bullish predisposition or bearish predisposition, and we will be ready to look for the best moment of entry. In the following image, you can see a daily chart of the EUR/USD currency pair with an exponential moving average (EMA) of 50 days and a 100-day EMA, a combination that seems to adapt well to the current situation of the pair and the timeframe used. However, you will have false signals regardless of the combination of moving averages you choose or whatever trend indicator you use. False signals cannot be avoided.
Trend Confirmation Indicators
Another type of technical indicator or tool that we will need are the indicators used to confirm the market trends that we have already identified. As mentioned in the previous point, we will have false signals with any trend following indicators we use. The goal now is to improve the chances of prediction success using another tool that confirms the trend detected.
Like the trend indicator, the trend confirmation indicator can be used to generate buy or sell signals but it is not its main objective. The objective, in this case, is to see if the indicator that shows us the trend is confirmed. Thus, if both indicators coincide we can have greater confidence in the attitude we adopt towards the market.
A very common trend confirmation indicator is the MACD (Moving Average Convergence Divergence). The MACD histogram shows the difference between two moving averages of different period. If this difference is positive, the histogram is plotted over zero and serves to confirm the upward trend. On the contrary, if the MACD histogram is plotted below zero it will help us to confirm the downward trend. In a trading strategy that combines two moving averages and the MACD, we can see an example of the combined use of moving averages to detect the main trend and the MACD to confirm the trend and generate market entry signals. In the following image, we can see how there are periods in which the trend indicator we have chosen (combination of two moving averages) and the trend confirmation indicator (MACD) coincide in their forecast and periods in which they do not.
You can research and test your own combination of trend following and confirmation indicators. You can even add more indicators, although putting more indicators may only complicate the information provided by the price chart and in many cases does not offer much more real utility.
Price overbought/oversold indicators
Once the trend has been detected, we can enter the market as quickly as possible, this is when we confirm the trend. But another good option is to wait for a price pullback. Market entries in pullbacks aim to open positions at levels with lower risk. In other words, if we detect an upward trend we will seek to enter when the price has a bearish retracement and is ready to rise again. On the other hand, if we detect a downtrend we will seek to enter when the price shows a bullish reversal and is ready to go down again. To determine the best entry time during a pullback you can use indicators that indicates the overbought/oversold price condition.
The idea is that if we are facing an upward trend, we will enter when this indicator shows the end of an over-sale period, which would be equivalent to the end of the pullback. Similarly, if we are facing a downtrend, we will enter when this indicator shows the end of an over-purchase period.
For example, we can use the Relative Strength Index indicator or the Stochastic oscillator. In general, momentum indicators are used for this purpose. In the following image, we can see how the stochastic oscillator can be used to find good entries: for example, in the first red vertical line, the general trend marked by the two moving averages coincides, the MACD confirms the trend and the stochastic oscillator goes from more than 80 to less than 80 (more than eighty is an overbought condition) indicating the end of the bullish pullback so the price would be ready to continue lowering.
Stop-loss and take-profit indicators
We have detected the main trend, we have confirmed this trend and we have found a good time to enter. What do we need for the trade to be complete? A tool that tells us when we should close our position, either with loss or gain.
For example, the stochastic oscillator itself used above can be used in such a way that if we have a sell trade and the stochastic falls to oversold levels then we will close the position. However, depending on the trading style used, this may cause the trader to close his positions too soon, as you can see in the previous image.
I like to let the positions I open mature with medium-long term trends. You could use, for example, the Parabolic SAR as a trailing stop, or simply set a trailing stop at a safe distance and let the operation take place. Or better, I can move the stop loss to support/resistance levels that the price is going through.
In the following image you can see the ATR indicator applied as a trailing stop:
As we have seen in this article, combining 4 types of indicators, or rather, 4 types of analysis tools, we can have a complete trading strategy that tells us what is the main market trend and confirms it to increase the possibilities of success. A good strategy developed through this methodology shows us the best time to entry and also the best time to exit.
