Welcome to Lesson 2. Here we will be learning about the indicators. These indicators are very powerful tools that can be used in conjunction with the charts to get a very detailed idea of the price movements for any given underlying asset that is being traded in binary options. At the end of this lesson, you will learn how to use these indicators to your benefit.
Technical Indicators Commonly Used
There are several technical indicators that are available to analyze the markets in binary options trading. These are based on very complex mathematical formulae but we are in luck because, as we said, we use these indicators along with chart and hence, all chart providers will actually do the mathematical part. All you have to do is to select the indicator and find out what it tells about the market. Thus, in our study, we will simply skip the mathematical part because we do understand that not everyone can have equally sound mathematical analytical abilities and any details we provide can actually leave you utterly confused!
Here are the technical indicators that we are going to cover in our chapter:
- RSI or Relative Strength Index
- MACD or Moving Average Convergence/Divergence
- Fibonacci Retracement
RSI or Relative Strength Index
Developed by J. Welles Wilder in 1978, RSI is used for determining the internal strength of a value. It is an oscillating or momentum indicator required for measuring the change and speed of price movements. The minimum value allowed is 0 and the maximum value allowed is 100. The indicator will oscillate between these two extreme ranges. Traditionally, as told by Wilder, when the indicator reaches and crosses 70, an asset is said to be overbought. This means, there will be a downward or Bearish correction and the price of the asset will start to fall. On the other side, when the indicator reaches and crosses 30, an asset is said to be oversold. This means that there will be an upward or Bullish correction and the price of the price of the asset will start to increase.
What about an equilibrium?
The rule of thumb in economics is that demand and supply has to be in an equilibrium. So, there should be a position where an asset is neither oversold nor overbought. This is depicted by the value 50 in the RSI. So, whenever the price of an asset will exceed the RSI index of 50, there will be a tendency for a downward correction. It may happen immediately but still, traders may just continue to buy and the price will continue to rise until the asset is overbought.
On the other hand whenever the price of an asset will fall below the RSI index of 50, there will be a tendency for an upward correction. It may happen immediately but still, traders may just continue to sell and the price will continue to fall until the asset is oversold.
MACD or Moving Average Convergence/Divergence
To understand MACD, we need to first understand the Moving Average or MA. MA is an indicator for following trends. It is derived by smoothing the price data. You always need to remember that MA never represents the future direction of the price but rather gives the current direction. It is always based on past prices and hence, there will be a lag.
There are two types of MA – Simple and Exponential.
To calculate MA, you need to take the closing prices only. You also need to determine the number of days you want to take account of. So, you may want to take account of 5 days, 9 days, 12 days, 26 days or whatever you want.
We will not be covering the topic on Moving Average but instead give you a wonderful resource that gives a full-scale explanation of how Moving Averages are calculated. The explanation is ridiculously simple and elaborate with super simple calculations shown that just anyone can understand. Those guys have done an excellent job explaining the Moving Averages. Probably they have done it better than us and the explanation is complete with simple charts. Here is link that you need to see.
We will go ahead with the explanation of the MACD or Moving Average Convergence/Divergence. Assuming that you have gone through the link and you understand MA properly, MACD will use two Exponential Moving Averages (ema). One of these ema will be a 12-day ema and the other will be a 26-day ema. The 26-day ema shows slow price movements (i.e. it is less reactive to price changes) and the 12-day ema shows faster price movements (i.e. it is more reactive to price changes). We will like to stress that for our explanation we are considering a 12-day and a 26-day ema but in reality you can use as many number of days as you want.
Now MCDA is calculated using the following formula:
MCDA = (12-day ema) – (26-day ema) [Note: we always subtract the ema with larger number of days from the one with smaller number of days]
This formula will yield a single line which is the MACD.
Once we have the MCDA, in order to make it work, we will need another ema with even shorter number of days. For our explanation we use a 9-day ema as our second line.
Now simply superimpose this 9-day ema on the MACD. This is how it will look like:
In the above image, the black line is the MACD and the red line is the 9-day ema. MACD is numerically represented as MACD (12, 26, 9). Here 12 is the 12-day ema from which 26-day ema represented by 26 is subtracted and 9 represents the 9-day ema against which we will measure the price changes. The blue histograms you see is actual change in price of the asset. Some chart providers may simply show a smooth shaded area instead of histograms. It is all the same!
We know it turned out to be a little complicated here but here is the good part – in case of binary options, we will be concerned with the MACD (in our example it is the black line) and the single line ema (which in our example is the red line.
How to interpret?
When the black line (MACD) crosses the red line (9-day ema) from above and moves down, the market is Bearish and you need to use Put option. When the black line (MACD) crosses the red line (9-day ema) from below and moves up, the market is Bullish and you need to use Call option. The point where the two lines (MACD and 9-day ema) cross each other or touch each other is neutral point where the market is in equilibrium.
Fibonacci retracements are used for finding out the support and resistance points. To do this, we make use of the Fibonacci numbers. Fibonacci numbers are a series of numbers starting with 0 and 1 and can extend to infinity. These are not just any numbers. They have special mathematical relationships. Here is a Fibonacci series: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377…
The series starts with 0 and 1. Now after that, every subsequent number is the sum of the previous two numbers. So, this is what you get:
0+1 = 1, 1+1 =2, 1+2 = 3, 2+3 = 5, 3+5 = 8, 5+8 = 13, 8+13 = 21, 13+21 = 34 and so on…
Other mathematical relationships:
- Whenever a number is divided by its previous number, the value gradually approximates to 1.618. Example: (21/13=1.6153, 34/21=1.6190, 55/34=1.6176, 89/55=1.6181)
- Whenever a number is divided by its next number, the value gradually approximates to 0.6180. Example: (13/21=.6190, 21/34=.6176, 34/55=.6181, 55/89=.6179 etc….). When the approximate value 0.6180 is converted to percentage, it is 61.8% and this is used for retracement.
- Whenever a number is divided by its next to next higher number, the value gradually approximates to 0.3820. Example: (13/34=.382, 21/55=.3818, 34/89=.3820, 55/=144=.3819 etc….). When the approximate value 0.3820 is converted to percentage, it is 38.2% and this is used for retracement.
- Whenever a number is divided by a number three places higher than it, the value gradually approximates to 0.2360. Example: (13/55=.2363, 21/89=.2359, 34/144=.2361, 55/233=.2361 etc….). When the approximate value 0.2360 is converted to percentage, it is 23.6% and this is used for retracement.
1.618 is the Golden Mean or Golden Ratio. It is called the Phi and it occurs naturally in almost everything in this Nature. You can find it in architecture, biology, art etc. The inverse of Phi or 1.618 is 0.6180. So, 61.8% is called the Golden Retracement.
So, what is this retracement that we are talking about?
There are two things that take place:
- Prices show a trend over a long term.
- That trend gets reversed at a certain point and starts moving in the opposite direction.
When the trend changes it is called Price Reversal.
Within a trend, say upward trend, the price will start moving up and then temporarily fall and then again start moving up and again fall temporarily and then again resume the upward move. These temporary reverse movements in prices are called retracements.
This is an example of retracements:
These Price Retracements follow mathematical relationships between Fibonacci Numbers. The price of an asset will generally retrace by 23.6% or 38.2% or a Golden Retracement of 61.8%. Though 50% is not a part of Fibonacci Numbers, it is generally used because of Dow Theory which says that prices can retrace up to 50% of initial move.
23.6% retracement is considered Shallow Retracement while 38.2% to 50% retracement is called Moderate Retracement and 61.8 retracement is called Golden Retracement because it is based on the Golden Mean – Phi.
These 23.6% or 38.2% or 50% or 61.3% retracements can be used as support and resistance levels because once the price retraces back by those percentages of the initial price move, there are chances that price will resume its initial move and based on this, traders can place their trades.