Having understood how an indicator works from the basics article from this series, let’s try to construct a very simple indicator to apply the fundamentals so we can better understand how an indicator works.
So, we’ll start with the question of, what data do we want to focus on? Remember that the purpose of an indicator is to strip away the noise from the market to find a pattern.
A simple pattern might be: is our currency pair going up, down or just being lazy? A straightforward tool for that would be a simple moving average or SMA.
A simple moving average compares the open price to the close price and finds the midpoint between them. This average allows us to ignore the “noise” of how much the market is jumping around during a certain period and focus on where it’s actually going.
The SMA works by calculating the midpoint of each candlestick, then adding them over a set number of periods so you can track the average movement of the market – essentially “ignoring” the data at the ends of the candlesticks as noise.
This is, of course, not an indicator with any level of sophistication. It’s just a simple moving average; how can we extract more information from it? Well, we can use two different SMAs: one from a shorter period, and one from a longer period. This would allow us to compare the short-term trend with the long-term trend.
We can get rid of the candlesticks now, and focus on our two SMAs. They should look something like this:
The blue line is the long-term SMA and the red line is the short-term SMA. In order to use this to generate signals, we have to observe patterns. We can compare the two trends; while the long-term trend is going in one direction, as in this case, upwards, then the short term will keep crossing over it. In fact, mathematically, before the blue line can change direction, the red necessarily has to cross over it. There are two observations we can make:
- Since the long-term trend of the market is on the upside, it’s more likely to have winning buys than sells.
- We can see that every time the red line crosses the blue it continues in that direction for a while.
So, based on that criteria, we can use these two SMA’s to give us signals to enter the market every time the short SMA (red) crosses the long SMA (blue) the direction of the long trend:
Congratulations! You’ve just created an indicator – or, as people often call it – a strategy. How effective would it be? Well, that’s when you’d have to test it.
Of course, most indicators are significantly more complicated than this, using histograms, geometric averages, price differentials, and others. However, they all work on the same principle of using a statistical tool to clear out the noise so as to focus on a particular set of data, and then compare that with a second statistical tool, which can be just a different version of the same tool. From there, patterns are identified to be used as signal generators.
The SMA is, on its own, an indicator; and here we played two SMA’s off each other. You can do the same with more sophisticated indicators, as well.