How To Use Indicators In Simple Trading


"Although measuring omega-3 levels in the blood seems like it would be an objective and accurate indicator of fish oil intake compared to using the subjects' reported dietary intake, this test does not accurately reflect long-term dietary intake."
-- Joel Furhman
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Nearly all technical indicators technically [see what I did there?] fit into five categories. Each category can be further subdivided into leading or lagging. Leading indicators supposedly predict where price is going while lagging indicators report background conditions when price is already in motion [i.e., lagging indicators summarize and report where price has been]. In truth, I think all indicators based on price behavior and/or volume are lagging as they're all enabled by what price and volume have already done.

At any rate, here are the designations based on the stated false dichotomy:
  1. Trend Indicators (lagging) - analyze whether a market is moving up, down or sideways over time.
  2. Mean Reversion Indicators (lagging) - measure how far a price swing has stretched before a counter impulse might trigger a retracement [reversion] back in the direction from whence it has come.
  3. Relative Strength Indicators (leading) - measure oscillations in buying and selling pressure and compare that pressure to previous points in time and/or against other securities.
  4. Momentum Indicators (leading) - evaluate the speed of price change over time.
  5. Volume indicators (leading or lagging) tally up trades and quantify whether bulls or bears are in control.
For the record, I disagree with the industry characterization of any of these indicators as leading since they are calculated based on past data, but mine is certainly the minority view. In reality, the best simple trading use of all price/volume indicators I've ever reviewed [and that's a large number] is as providers of context as opposed to predictive tools. It's a relatively small, but tremendously important distinction.

Most novices follow the herd when building their first trading screens, grabbing a handful of preset indicators and stuffing as many as possible on, over or under the price bars of their favorite securities. They do that because... well... "if 1 is good, 3 must be outstanding right?" Further, their real goal tends to be loss avoidance [see How To Think About Trading Losses below] rather than maximation of the profitability of their trading strategy.

Don't do this. This "more is better" approach short circuits signal production because it looks at the market from too many different angles at once. Which in turn, essentially complicates the study and, more often than not, the signals cancel each other out. It’s ironic because indicators work best when they SIMPLIFY analysis, cutting through the noise and providing usable inference based on trend, momentum, timing... in other words... CONTEXT.

You're welcome.

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