Posted by: Bevan | May 2, 2010

Indicators

A video on YouTube (http://www.youtube.com/watch?v=h_caNPnoDdI&NR=1) by Stuart McPhee got me thinking about Indicators.  Someone recently was talking to me about the power of Price Action.  The debate over the value of indicators will never end.  On one hand there are plenty of gurus, trading courses and forum posts describing their use, and on the other hand there has been a fairly substantive backlash against them as well.  They are accused of being ‘lagging’ and of having no forecasting power as they are based on the past.

A very busy chart captured early in my trading career

Like most traders, when I began trading I experimented with a few systems combining together moving averages with several oscillators.  None worked for me, although I only tried them very briefly before trying something else.  They always appeared to have predictive powers when looking back on the charts but that didn’t translate to realtime performance.  This experience probably leads most people to conclude that they don’t work, however I think that the real issue is with they way they are used.  Understanding the makeup of an indicator is vital.  It certainly is true that indicators on their own don’t have predictive power – usually past successes are the result of our eye lining up patterns in much the same way that classical chart formations like head and shoulders in past charts appear to work.  Its amazing what applying a ruler vertically shows – usually the successful signal is found not to line up with the beginning of a move at all.  Markets just aren’t the sort of places where mechanically following a popular indicator is going to lead to a stream of profits – that would be too obvious and easy.  Have a look at page 171 of Hill & Pruitt’s The Ultimate Trading Guide – “Of all the indicators that are out there, only a handful are worth more than a grain of salt”.  They then test some popular indicators including RSI, MACD, Stochastics and CCI.  The results are there in black and white, on their own these indicators lose money.

Many of the PDF trading systems for sale on the Internet go a step further and combine lots of indicators together.  For example the Profitable Trend Forex System (“Discover how to make 600 pips a month consistently”) combines traditional Exponential Moving Averages, two other ‘exotic’ types of moving averages and MACD together, all with custom parameters.  Overall the system is made up of at least six parameters.  Its not surprising that the system might have shown some good results, especially tested on one Forex pair over a short amount of time – with that number of parameters it wouldn’t be hard to ‘fit’ the market for that period.  Of course this will fall apart in the future as it is curve fitted beyond belief.  Furthermore, combining together these indicators is pointless – they are all slightly different derivations of price using very similar calculations.  Would you expect to gain an edge in the market by making decisions based on eight moving averages of different lengths? All you’d make with that is spaghetti!

Its here that I will come to the defense of indicators though.  The issue is understanding how an indicator is made up and how it works and behaves.  This is uncommon in the age of free charting packages with dozens of indicators that can be turned on and off and manipulated at will.  The good old days of using spreadsheets and plotting indicators manually forced one to understand the derivation of indicators.  Welles Wilder invented a number of important indicators and described them in his book New Concepts in Technical Trading Systems – some reviewers criticise the book as being full of unnecessary detail about the construction of the indicators.  I think they miss the point – understanding how an indicator works allows you to intelligently incorporate it into an overall trading concept that makes sense and test it.  No indicator will work alone – instead an understanding of the information it gives, its strengths and its weaknesses can allow a trader to construct a logical system around it.  For instance if you’re trading Opening Range Breakouts, a very tradable and potentially profitable entry technique, a moving average would be a sound filter to keep you on the right side of the trend.  Just make sure it does actually work (test it) and equally important make sure it is robust i.e. that it works over a large number of markets and over a long period of time, and that changing the parameter (the length of the moving average in this example) doesn’t dramatically alter your results.  Understanding an indicator and using it in a logical and sensible way (without expecting it to deliver pinpoint entry and exit signals) can be a profitable exercise, however as with anything in trading it should be tested and part of a logical trading system which is based on sound market principles, and incorporates all the elements of a successful method (setup, entry, risk definition, exit and position size).

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