Technical analysis is wonderfully suited for the trading of binary options based on certain underlying asset-categories. Obviously, there are assets out there which are best traded with solid fundamental analysis, but as a general rule, the technical and fundamental aspects of the analysis process are not mutually exclusive, quite the contrary: they complement one another wonderfully. As you probably know, fundamental analysis is about the various economic news and their impact on the price-evolution of various assets. Technical analysis on the other hand is about the identification, interpretation and exploitation of chart patterns and as such, it is a tad more detached from the actual forces driving the market. Coupling the two types of analysis results in solid trading signals which are checked and doubled checked to make sure they do indeed hold water.
In this article, we’ll take a look at some of the indictors which serve as the basis of most technical analysis-based binary option strategies. In order to understand why technical indicators work the way they do and why those we’re about to discuss in detail are the most important, you need to understand the factors based on which they function. Binary options trading is all about probabilities: with an all-or-nothing type of outcome, binary options are bound by time and by a condition (which they need to fulfill in order to turn a profit). As such, all technical indicators need to cover all the following factors: volatility (how much of it is needed for the asset-price to cross into profit-territory), price-movement direction and timing. Technical indicators can be exploited in two ways when trading binary options: one can bet on the continuation of a trend based on the signals generated by the indicator and one can bet on an impending trend-reversal.
The stochastic oscillator is arguably the best-known technical indicator out there. Defined as %K, which equals 100*((C-L14)/(H14-L14)), where C is the current price-level, L14 the price low of the previous 14-cycle period and H14 the price high of the same period, the stochastic oscillator is an indicator designed to follow the momentum of the price change. The logic behind it all is that momentum shifts before the actual price does. Also needed for the proper functioning of the stochastic oscillator is %D, which is a 3-day moving average of %K. A range-bound entity, the stochastic oscillator indicates overbought and oversold levels in an asset-price. More precisely, levels above 80 indicate an overbought situation, while levels below 20 point to an oversold situation. The trade entry-signals are indicated by the crossing of the %K and %D lines.
The Bollinger bands are all about volatility. They work hand-in-hand with the simple moving average, forming two bands above and below it, the contraction and the expansion of which herald upcoming trend reversals. Above and beyond this use, the Bollinger bands – like the stochastic oscillator – also indicate overbought/oversold situations in the asset-price. More precisely, when the current price of the asset is situated above the upper Bollinger-band, we’re dealing with an overbought situation. When the current market price is below the lower band on the other hand, we’re looking at an oversold situation.
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When it comes to riding an existing trend to profits, Wilder’s Directional Movement Indicators Average Directional Index is the indicator you’re looking for. Made up of three lines, DI+, DI- and ADX, this indicator gives a measure of the strength of an already ongoing trend. Whenever we’re dealing with an uptrend, the DI+ will be situated above the DI-. In downtrends, the DI- is above the DI+. What we’re really interested in though is the value of the ADX which tells us whether we can bank on a sustained trend or not. An ADX value above 25 indicates a strong trend, while one below 25 points to a weak trend.
The pivot point, which is always used in conjunction with support- and resistance levels, is one of the most commonly used tools in the arsenals of binary option traders. The pivot point is a good indicator when it comes to trading major currency pairs.
The Commodity Channel Index is another highly popular indicator, also suited for the trading of binary options. The CCI compares the current price of an asset to its average price (the moving average is used to this end) over a given period of time. From a binary option-trading perspective, the flexibility of the CCI is a great asset, as it lets traders adapt it to various expiry-periods. The CCI is good for the identification of new trends as well as for the pinpointing of extremely oversold and overbought market conditions. It is great for short-term trading and it – like the other indicators above – can be combined with other indicators to generate more refined trading signals. The formula which defines the CCI is: (C-MA)/(0.015XD).
C is obviously the current price here, while MA is the Moving Average and D is the normal deviation. As far as the interpretation of the CCI goes, in a nutshell: if the value is higher than +100, we’re looking at the start of a massive uptrend. If the value is <-100, we’re witnessing the beginnings of a strong downtrend.
All the above taken into account, it is safe to say that technical indicators are indeed potent tools in the hands of those who know how to use them. A word of caution in regards to everything based on technical analysis should be inserted here though: all such analysis is based on past data and as such it can result in false trading signals. Technical analysis is far from fail-safe, but its results can be improved through the use of multiple indicators, as well as through some fundamental analysis added to the mix. If several factors confirm a trading signal, the trader can be much more comfortable with it.
With binary options, the use of demo account-based back-testing is also available and should definitely be put to use.
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