Trading with one technical indicator is okay, but trading with a combination of indicators is better. The question is, how to combine forex indicators the right way?
In forex trading, traders are very likely to face different types of analysis. Some prefer fundamental analysis, but others prefer technical analysis and even combine indicators. Trading with indicator combination might seem complicated at the first glance. That's why here we will learn how forex indicator combinations actually work. We also will try some of the most recommended combinations that you can apply to your forex trading.
Risk of Redundancy
Many traders think that simply combining indicators will automatically yield the best trading results. This seems like a logical approach to trading, but more does not always mean better. One critical factor that should be remembered is that indicators have their own function. Mixing two indicators with the same function will only lead to double signals. In other words, it's a redundancy.
Now let's see what this is all about with the example below.
The chart above uses two indicators, which are the Bollinger Band and ADX. Both indicators serve the same function, which is to gauge the trend strength. In a trending situation, the price moves closer to the Bollinger Bands. At the same time, the ADX line is rising, thus confirming the trend. In a ranging situation, the price is moving in the middle of the Bands, and the ADX mimics the signal with its flat and failing line.
Another example is when combining the RSI, CCI, and Stochastic indicators that react to price action pretty much in a similar way. This is because the three indicators are types of oscillators that are utilized to measure momentum.
It is completely okay to use both the Bollinger Band and ADX if we want to confirm a trend, or all of the RSI, CCI, and Stochastic to analyze a momentum. The problem arises when we are led to believe that the signal is stronger than it actually is just because two or more different indicators confirm one another. And worse, we rely heavily on this information and ignore other important variables in trading.
Categorizing Forex Indicators
Before choosing what indicators to use, we need to know what category an indicator falls under. With this categorization, we can choose the best combination where indicators complement one another instead of providing double signals. Here are some indicators and their categories:
- Momentum Indicators: Stochastic, RSI, CCI, MACD, Williams %, etc.
- Trend Indicators: Bollinger Band, ATR, MACD, ADX, Moving Averages, Donchian Channel, etc.
- Volatility Indicators: Bollinger Band, ATR, Standard Deviation, Keltner Channel, Pivot Point, etc.
Combining Forex Indicators the Right Way
Okay, we now have established the category of technical indicators. But as we can see, some indicators can be considered to be multifunctional. In fact, indicators can be quite versatile and be used under different circumstances. The bottom line is we should know exactly how to use the indicators.
First, we can use it to identify the market condition. For example, we want to know whether a market is trending or ranging. Let's say we use the Moving Average. If the MA is rising and above the price, we can conclude that it is an uptrend. However, it doesn't tell you anything about other conditions such as volatility. And for that, we will need a volatility indicator.
Next, pick an indicator that can trigger trading entries. The RSI is a good example of this. When the RSI is below 30, it signals that the market is oversold. Thus, when the RSI crosses above 30, we take this opportunity to enter a long position. Another example is the Donchian Channel. The price crossing the upper or lower line of the Donchian Channel is a signal for entry.
Lastly, find indicators to help our trade management. We can set our stop loss, trailing stop loss, or profit target by taking advantage of indicators such as the Pivot Point or ATR. For example, we can set our support and resistance levels based on the calculation of Pivot Point.
To combine indicators, we will need one indicator from each category. Also, we should not combine more than 3 indicators. Here are some of the best combinations you can try.
1. MA, RSI, Pivot Point
This combination works well for swing trading in trending markets. The Moving Average analyzes the trend, the RSI measures momentum, and the Pivot Point identifies the volatility. We can use 200 EMA and 10 RSI for the setup, although you can adjust it on your own.
Let's see the chart below.
We can see that the price moves above the 200 EMA, therefore the market is in an uptrend. Thus, we are waiting to buy. If we take a look at the RSI, it is still moving lower. This tells us that the market is not yet oversold. Our projection is for the RSI to moves below 30 and then cross back above 30. When this signal is triggered, we can calculate the Pivot Points and use them to determine the profit target, whether it is R1, R2, or R3.
2. ATR and Donchian Channel
For the next combination, we will use the ATR and Donchian Channel. This particular combination is for breakout trading which is more suitable in low volatility markets. Thus, we identify the volatility first with the help of ATR.
As the entry signal, we take a look at the Donchian Channel.
- When the price crosses above the upper band, we enter a long position. Use trailing stop loss to close the position.
- When the price crosses below the lower band, we enter a short position. Use trailing stop loss to close the position.
See the charts below for examples:
3. RSI and Bollinger Band
In this combination, we use RSI as a momentum indicator. When the RSI is low and falling, it signals strong downside momentum. Likewise, strong upside momentum is indicated by a high and rising RSI. The market lacks momentum if the RSI is around 50.
The Bollinger Band here functions as a volatility and trend indicator. We can get information regarding the trend by looking at the price action in relation to the Bands. Price moving close to either outer Band is a trending signal, price crossing the middle Band signals a reversal, and price that hovers between the middle and outer Bands indicates the trend is fading.
See Also: Bollinger Bands and SMA Combo Strategy
Here's a chart to show you how this combination works.
4. RSI, ADX, Bollinger Band
For the next combination, we will add the ADX indicator to the above combination. Since the ADX is a trend indicator, we will use the Bollinger Band exclusively as a volatility indicator. Also, the RSI still functions as a momentum indicator.
If the ADX is high and rising above 30, the price is trending. Look for confirmation from the rising momentum of the RSI. When the ADX has lost the bullish trend and becomes invalid by falling below 30, it means the market is in range. In this situation, we rely only on the RSI and Bollinger Band.
In a sideways market, we can get clues from trendlines and the Bollinger Band rejections as well as from RSI breaking the momentum boundaries, which is either 70 or 30 in this case.
5. Bollinger Band and Stochastic
The Bollinger Band indicator provides information regarding the trend direction, while the Stochastic gives prediction on the trend strength. Considering that the Bollinger Band is a lagging indicator that follows the candlestick pattern, we should always read the signal from this indicator with caution. That's why the Bollinger Band indicator should be combined with one or two other indicators to complement the trend signal, for example by using the Stochastic.
As a momentum indicator that has the characteristic of an oscillator, Stochastic is a leading indicator that provides information when the market is overbought or oversold. In addition, this indicator can also give the signal for an accurate entry when the %D line crosses the %K line.
Using the combination of Bollinger Band and Stochastic, we can enter a position if the conditions below are met:
- The price is closed above the upper band or below the lower band. If the price is closed above the upper band, this is an uptrend signal. Oppositely, if the price is closed below the lower band, this is a downtrend signal.
- There is a crossover between %D and %K lines on the Stochastic. The %D crossing the %K from below is a bullish signal, while the %D crossing the %K from above is a bearish signal. The Stochastic generates the best signal when the crossover occurs above 80 (overbought condition) or below 20 (oversold condition). Place a sell order when the price moves down from the overbought area, and place a buy order when the price moves up from the oversold area.
Let's take a look at the example below.
On the EUR/USD chart above, the price was closed below the lower band. At the same time, the Stochastic made a crossover below the oversold area. In this situation, the price was inclined to make a bullish reversal and so we can use this opportunity to enter a long position.
6. RSI and MACD
This is another combination we can put into use. The MACD is an indicator that shows the trend direction and market momentum, while the RSI provides an entry signal through the oversold and overbought levels.
The uptrend and downtrend condition can be seen from the OsMA on the MACD histogram. A positive histogram indicates an uptrend is ongoing, while a negative histogram signals an ongoing downtrend. The MACD can also give entry signals when a crossover between the 12 EMA and 26 EMA occurs. We can enter a buy order when the 12 EMA crosses above the 26 EMA, and a sell order when the 12 EMA crosses below the 26 EMA.
Even though we can execute a trade based on the MACD alone, it is better to complement this indicator with the RSI indicator to provide more reliability on the entry signal. Like the Stochastic, the RSI also helps determine overbought and oversold conditions, as well as accurate entry points.
Therefore, we should enter a position if the combination of MACD and RSI has met the following conditions:
- See whether the market is in an uptrend or downtrend by using the MACD histogram. If the OsMA is positive, it is an uptrend, and vice versa.
- A crossover between the 12 EMA and 26 EMA of MACD occurs. The 12 EMA crossing above the 26 EMA signals a bullish reversal (buy order), while the 12 EMA crossing below the 26 EMA signals a bearish reversal (sell order).
- The RSI line hits the overbought or oversold level. However, it is important to note that these levels are not absolute. Some traders use level 30-70, and some use level 20-80. If the RSI line hits the oversold limit (20 or 30), we can enter a buy order, and if the RSI line hits the overbought limit (70 or 80), we can enter a sell order.
Here is an example of the MACD and RSI combination.
From the chart above, the RSI moved into the oversold area and gave a buy signal. At the same time, the MACD histogram identifies a bullish crossover between the 12 EMA and the 26 EMA, which was a signal for us to buy. These two indicators complemented each other, thus we could enter a buy order confidently.
See also: A Trader’s Guide to EMA Strategy
RSI or Stochastic, Which One Should be Used?
From the five combinations above, you probably have noticed that we use both the RSI and Stochastic to identify momentum. Despite belonging from the same category, we should apply either indicator based on the market environment.
The RSI oscillates between 0 and 100. An RSI above 70 indicates a possibility of overbought condition, while an RSI below 30 indicates a possibility of oversold condition. That said, the price doesn't necessarily make a reversal if the RSI hits extreme levels.
Generally, traders will use an RSI of 50 as a signal for an ongoing trend. An uptrend occurs when the RSI is between 50 and 70, while a downtrend occurs when the RSI is between 30 and 50.
On the other hand, Stochastic works better when it comes to identifying price reversal. Although it oscillates between 0 and 100 just like RSI, the Stochastic uses 20-80 as the signal. A Stochastic above 80 indicates an overbought condition, thus signaling a potential bearish reversal. Likewise, a Stochastic below 20 signals an oversold condition, thus signaling a bullish reversal. The Stochastic will also remain at its extreme level (overbought or oversold) even when the market is trending. This is because the price is always closed near its highest level (for uptrend) or its lowest level (for downtrend).
We can see the differences between these two indicators on the chart below.
From the chart above, we can say that RSI is more accurate in a trending market compared to Stochastic, provided that we only use 50 as the signal for trend direction while ignoring its function to identify overbought and oversold conditions. Stochastic, on the other hand, is more accurate in a sideways market.
The RSI is also best applied to shorter time frames in order to measure the velocity of price change and short-term trend. Meanwhile, Stochastic is usually implemented by swing traders to identify mid to long-term momentum.
The best forex indicator combination constitutes indicators that are complementary to one another. Using two indicators that have the same function and purpose is redundant; it does not mean that the signal is stronger for you to enter the market. Therefore, a combination with one indicator from each category is the way to go. It provides you with different perspectives from the same price movement, so you can see whether a trade is possible. What matters most is to don't test indicator combinations in a real account. Instead, use a forex demo account to see how they work so you don't risk any real money for your strategy testings.