How to use Trading SignalsMaking the Most of Signals
Do you use trading signals?
Are you currently struggling to generate returns from these signals? This is something that many traders are currently experiencing.
However, is this because of the trading signals that are being followed or is it the trader that is not making the right decisions and does not know how to use trading signals?
When it comes to Binary and Forex trading, signals are a tool and should not be a crutch.
From that perspective, a trader should have a strategy when using signals just as they do for their other trading endeavours.
It is not just a matter of turning on the signal provider and then blindly following the signals and placing the trades.
The trader has to know what trade limits to implement, what entry levels are best as well the best stop losses to put in place.
In this short overview, we will run over some of the most important indicators which drive signal software and how to use them effectively to make the most profit.
The Parabolic SAR
One of the best known signals that one can use is the Parabolic SAR. This is also known as the Parabolic Stop and Reserve. It is a combination of a price and time based technical analysis signal.
The Parabolic SAR was developed by Welles Wilder in 1978. The Parabolic SAR is used to trail prices with the trend that it is following. Given that it is trailing, the indicator will be below prices when there are falling and it will be above prices when there are rising. We have an example of the Parabolic SAR in the chart of the New Zealand dollar to the right.
Generally, when the prices are above the Parabolic SAR indicator then the trader will enter a long position and buy the currency. On the flip side, if prices are below the indicator then the trader will sell or go short the currency.
However, the real significance for traders from the Parabolic SAR is allowing the trader to place stop losses. Essentially the trader will use the indicator to place his / her automatic stop levels. Once the price has broken past the Parabolic SAR, this is an indicator that it has broken a trend and is possibly in line for a reversal.
What automated signal software will do is try to generate a signal based on whether the Parabolic SAR is indicating that the trend is reversing its current levels. If the software detects that the price is breaking away from an uptrend then it will issue a sell signal. The converse is of course true for a price that goes above the parabolic SAR.
Of course, using Parabolic SAR signals can be effective but you need to make sure that you are using some precautionary methods before entering the trades. These include some of the following.
- When entering the trade, your buy and sell should be the averages of the lowest and highest prices for the previous 4 candles.
- Do not trade more than at least 4% of your account size on any signal position
- If you are trading Forex, set adequate stop loss limits that are on the level of your parabolic SAR indicators
- When you decide to enter the trade with a Parabolic SAR indicator, you should make that decision based on where the current price is in relation to the indicator
Moving Average Indicators
This is one of the oldest and most important technical indicators. The moving average indicator is an extremely effective way for the trader to monitor the trend of the asset. There are two types of moving averages that trading signal providers use when generating signals.
The first is the Simple Moving Average (SMA). This is essentially calculated as the average of the last x periods where “x” is the time period under consideration. Many traders combine an SMA indicator with different time periods to get the best indicator of trend.
We can see in the example to the right a strong uptrend on the price of Bitcoin with three different moving average indicators.
Another moving average indicator is the Exponential Moving Average. This is quite similar to the SMA with the only exception being that the weighted version places more emphasis on the most recent price levels. Essentially, higher weight is place on these levels in the calculation of the moving average. This can be beneficial to the trader as it allows him / her to make the most informed decision when the markets are moving quickly.
Moving averages are lagging indicators. This means that they are as a result of events that have already taken place and are not necessarily predictive. However, where the moving average indicators is most useful is in establishing the strength of a market trend.
It is helpful for the trader to spot the trends through all of the market noise. In a similar fashion to the Parabolic SAR, the Moving Average can also point to potential reversals in the trend. A signal provider will also look at the moving averages to produce the signals. They will usually use an algorithm that looks at two or three different moving averages.
The algorithm will then set predefined rules on what signal to provide based on the levels of all of the moving average lines. If you are going to be following the signals of a provider based on the moving average indicator, you need to take the following risk management steps.
- Commit only a pre-defined trade size when entering. This should be no more than 4%.
- Trading decisions should always be based on the positions of a number of moving average indicators with varying time parameters
- Set buy and sell points that are the average of the previous 4 candle sticks
Moving Average Convergence Divergence (MACD)
The MACD indicator is an extension of the moving average indicators that we talked about previously. The MACD indicator uses two different EMA indicators as the input into its formula. Unlike moving averages only, the MACD is an indicator of when to buy and sell a particular currency pair.
The MACD is calculated by subtracting the 12 day EMA from the 26 day EMA. Further, a 9 day EMA line is used and is termed the “signal line”. These two lines are plotted together and the 9 day moving average is used as the indicator of whether to buy or sell. In the graph on the right, we have the price of the Japanese Yen and the corresponding MACD chart and signal line.
As a general rule of thumb, when the MACD indicator is below the signal line then this could be an indicator to sell the pair and the opposite can be said when the indicator is above the signal line.
Conversely, when the signal line diverges from the MACD then the trend that was in place can be considered over and traders should take caution. Traders should also be aware of strong upward moves in the MACD as this could be an indicator that the currency pair has been overbought and the 12 day moving average is increasing substantially compared to the 26 day one.
Algorithmic trading software also uses the same logic when producing trading signals for traders who subscribe to the signals. The software will monitor the levels of the MACD and the signal line and generally adjust the signals being generated based on historical volatility. If the uptick in the MACD is within previous standard deviations then overbought signals will not necessarily be issued.
When making use of MACD trading signals, keep these in mind before entering your trades.
- As always, have a set maximum that you are willing to invest as a percentage of your total capital balance.
- Entry decisions should be based on how far the signal line is from the MACD indicator. This should also take into account how volatile the indicators have been in the past in relation to the current observed movement.
- Entry and Exit levels should be based on the observed prices over the past 4 candles.
- If trading Forex on margin, you should have adequate stop losses in place that are well placed to obtain the desired return on the upside but also won’t allow for too much drawdown if a reversal were to occur.
Developed by John Bollinger, Bollinger bands are another technical indicator that goes all the way back to the 1980s. Bollinger bands are similar indicators to those of the Moving averages with an important addition, that of volatility.
This is very important as volatility on the price is a key indicator of whether the trend or possible reversal that you are witnessing is temporary and within reasonable bounds or a more permanent trend change.
Bollinger bands are usually plotted as three lines. There is the middle Bollinger band which is usually a moving average over a specific time period. Then, once the middle Bollinger band has been plotted, two additional lines are drawn which are the upper and lower bands. These are the middle band plus or minus the standard deviation. In the image on the right, we have the 20 period Bollinger bands plotted with 2 standard deviations.
The trader can choose how many standard deviations from the trend they would like to examine for the pair. Taking a look at a quick example, in the graph on the right we have the EURUSD Bollinger bands with a 20 look back period and 2 standard deviations either side of the trend.
The way that traders are able to produce signals based on the Bollinger band is to determine how far away from the trend the price has broken and whether that is reason to enter a trade based on possible reversals.
As a general example, assume that the price had broken above the middle band and had touched the top band. Many traders and algorithms see this top band as a resistance level. Hence, if the price is unable to breach this upper band, it is likely to retrace and is a sign the trader should short. Of course, the opposite can be said for a fall to touch the lower Bollinger band as a resistance and a possible entry for a long position.
On the other hand, if the price manages to break past the upper or lower Bollinger bands then this could be an indicator of a trend reversal and a signal that the trader should enter the position that conforms with the trend. This is just one example of how trading software will use Bollinger bands to derive their signals.
If you are deciding to use Bollinger Band signals to drive your trading, then you would need to take the following precautions before entering trades.
- Never allocate more to a Bollinger Band signal trade than a set amount. This can vary according to the parameters set by the trading software that produces the signal.
- Entry decisions should be based on the choice of standard deviation on the signal. Some signal providers allow you to define the number of standard deviations from the mean you would like signals to be generated on.
- As with the other indicators, entry and exit levels should be based on the prices that were observed over the previous four candles.
- Stop losses are key when it comes to Bollinger band signal trading. The Bollinger bands themselves are also quite helpful when placing stop losses. Usually, one can plot multiple bands and place a number of stops
A Comprehensive Strategy
Of course, the above signal types are only the tip of the spear when it comes to the number of trading signals a trader can use. Similarly, the manner in which the signals are produced using these indicators is much more involved than what has been described. Computer algorithms are able to incorporate a number of different variants of the same indicators and make use of advanced machine learning technology to adapt these algorithms to change.
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