Technical Market Indicators and their Workings

Q. But do indicators work?

After 9 months of trying to actively trade instead of investing, and being mildly down on my capital, I figure that my methods so far are pretty much throw a dart at the dartboard and hope for the best. The only bright side I have is that I'm down less than the market overall - but not by much.

There are things I have learned, mostly to do with trading discipline, but I think my methodology needs a serious overhaul.

I first started using a 10 Day EMA as my "fast moving" indicator, and a 26/12/9 MACD as my slow moving indicator, and when both agreed, I went in. The theory was that having a fast and slow moving indicator means I could get most of the movement, but miss the volatile whipsaws.

Obviously, since they're both moving average based, I decided this was bad, and started playing around with RSI - 5 day and 14 day Wilder. However, my feel is that RSI is still a moving averages based indicator, just with a different formula.

So, my question is, do indicators work?

My overall trading strategy is divide my capital into five, and spread them out across spread bets, no two being in the same sector. At any time, one or more of those five parcels can be in cash rather than in a spread bet, and positions can be long or short. Obviously a high risk investment strategy, but it's not my retirement money I'm playing with here. Just a spare 20k I have.

A: Technical indicators and charting are by no means a guarantee but you ignore them at your peril. They are equally a valid strategy as any other.

One of the strengths of charting and technical analysis is that it uses an objective set of figures - price activity - which are readily available to everybody interested in the market. How individual traders choose to apply and interpret those techniques is a matter of subjectivity. Just as charts provide a visual representation of the trading activity, indicators can help you visualize the underlying price action, and support and resistance levels resulting from it.

It's not rocket science either as most indicators are based on 'price' and 'volume'. Just understand that a particular setup that works when the market is trending will probably not work so well when it is not.

If you want to be in the market all the time, then you have to have a setup for each type of market condition, and recognise when market conditions change.

Depending on the timeframe used, a stock can be in an uptrend on one, downtrend on another and range trading on yet another - so you may have to use timeframe analysis to decide if or not to take a trade.

If you find a setup that you have 'faith' in - remember that the setup will occur across ALL timeframes - the higher the timeframe used - the easier it is to trade (less noise, giving clearer signals), the lower the timeframe, the more "expert" you have to be to make use of it.

If you can't make money trading say a weekly chart - then don't even consider trading a lower timeframe. It takes a lot of experience to be consistently profitable using a daily chart (anyone telling you differently is only kidding themselves).

Indicators work, EW works, pattern trading works...etc. Don't be put off by other people's opinions - they are only opinions - as is this message.

Do realise, however, that as a rule of thumb price based indicators lag price action. Can you base today's buying/selling on last week's data? Another problem with them is that they try to pick tops and bottoms (oscillators). You will get killed if the trend is strong (i.e. someting staying in oversold territory for months) or when its chopping. Do learn to read price action, volume, trend lines and maybe some other stuff.

At the end of the day, indicators, EW etc are just tools, in the hands of a good tradesman... Technical analysis tools such as the SMA/EMA used to spot trends and provide you with a moving stop loss when combined with indicators (MACD, RSI, Momentum) can show sentiment of the market and likely direction.

The key with technical analysis is to wait for a confirmation on any buy signal (whether it be a chart formation, support line, resistance line, wedge, ascending triangle...etc) If you do not wait for the confirmation of the buy signal and a confirmation is not forthcoming then it ceases to be a buy signal and if you jump the gun you will most likely get burned.

Which Indicators to Use?

There are many technical indicators you can follow - they work in combination but one of the most important ones is the 'Volume Indicator'. If the price is rising but the volume is diving, or vice versa, then you might want to consider stopping your position (safest) or reversing it completely.

Some indicators such as moving averages, work best in trending markets where the security is moving either higher or lower. Oscillators, on the other hand, such as stochastic, are best suited to a more range-boundor or choppy trading environment..

Also there is nothing wrong in trading from say, the monthly or weekly charts!! - there is serious money to be made there for comparatively less work , and it gives you a life outside of trading.

When market conditions become more favourable, I'll probably include trading from the monthly or weekly charts, easy to trade. Trading from the longer term charts is a much more relaxed style of trading, but still offers a very good potential return!

Longer timeframe trading cuts the stress/excitement level drastically and allows you to refine your setups without undue stress, Once you have refined your setups and gained trading experience you might want to consider trading a lower time frame, you will have the opportunity of more trades to choose from, which ultimately should result in a larger $ return each year.

For what it's worth, I use both indicators and price/volume/time analysis - and indicators play an important role in my trading although I don't rely purely on indicators for an entry or exit trigger but use them to confirm my overall bias. This is because even indicators can be wrong sometimes and while they may work for a time, when the market shifts, strategies built upon indicators alone will begin to fail unless major adjustments are made.

For me, one of the most important aspect of trading, from a technical analysis point of view - is understanding the various forms of Support/Resistance levels and the use of multi-timeframes coupled with pure price and volume action.

And be your own man - do not take anything you read or hear as gospel - check it out first.

And since you mentioned placing trades in different sectors - an understanding of inter-market and sector relationships may help as well.

The best advice for the inexperienced has to be control risk and preserve capital...Just don't give up - there's money to be made in the market when the conditions are correct.

Note: Some technicals like Bollinger bands, operate on the placebo effect, if enough people believe in them, and act upon them, then they can become self fullfilling. Personally, I'm more of a trend follower than a chartist...

Q. What are positive and negative divergences?

A: An indicator is the mathematical derivative of the price action and while the price action and the indicators move in tandem there are times when the two do not match which results in a divergence.

Positive Divergence

When the price action shows price 'low' is lower than the previous closing price, but the indicator does not dip below the previous dip in the graph, this indicates a positive divergence.

Negative Divergence

When the price action shows closing price higher than the previous closing price but the indicator peak does not cross the previous peak on the graph, this indicates a negative divergence.


Q. I heard someone saying that he uses 45 indicators. Can these all be useful?

A: Anyone with access to a £300 laptop these days can now number crunch with hundreds of different indicators. I think people get afraid of technical analysis because there's always someone round the next corner with another idea/setting etc..., and it can be very 'stressing' trying to figure out who is right. However, the fact is that the use of these indicators has been greatly diluted over the years and it will come up as a relief for those starting from scratch to know that there are many professional traders who have proven results over the years without using many indicators. In fact, there are some traders who just use one single indicator to trade (for instance CCI or 200 moving average), while others may use a combination of simple indicators and techniques like support and resistance or moving averages.

The trouble with indicators is that there are too many of them and a number are just duplicates of each other. Just to mention a few -: Relative strength index, Bollinger Bands, Head and Shoulders, Double Tops and Bottoms, Trendlines, Candlesticks, MACD, Moving Averages, Momentum, Support and Resistance, Coppock, Breakout, Average True Range, Accumulation index, Fibonacci levels and Pivot could of course also go the exotic route and have Gann's square of nine, Murray Math or even Pryapoint or Grid lines using square root of price...phew there's just an awful lot...

No doubt an increasing number of traders are learning about technical indicators and will use them to make trading decisions. Indeed some people will spend hours and hours trying to find that holy grail combination of indicators that will help them find the road to fortune. The fact is that no technical analysis tool by itself will give you reliable buy or sell signals. There is no magic blackbox and the fact is there are few indicators more appealing than a simple plain price and volume chart; try to focus on the shape of the graph - does it look bullish/bearish and are there any key levels of support/resistance coming up? Sure, some other indicators coupled with these might give you a heads up where something might happen but the price action with a bit of volume analysis will tell you what is happening. Combining this with discipline and adequate trading capital has been the road to success for many traders.

Jim Slater's Zulu principle can be applied to technical analysis - just set out to know a lot about a little and accept that there's lots more out there that you're not gonna know. Once I accepted that, the analysis paralysis disappeared and I could see the wood for the trees. I will always look at something new but only from someone who has convinced me they are making money using whatever it is. No proof, no look...makes life so much simpler.

So, when you have time, go and look at your portfolio on a simple chart with the 100 day moving average on it. Then report back on whether that indicator would have worked in getting you out at a point which would have made sense. If it doesn't then we'll move onto something else. Simple is better and I find there's no one tool which does the lot. Each tool is a voice adding to the sentiment, and if most of the voices are saying the same thing, that's as good as you get.

Modern life has introduced a new problem - that of information overload. It is very easy to expend all your efforts on researching indicators and trading systems and making it all way too complicated. In fact, what you really need is to keep it dead simple, such that you see your way forward.

Let's call the 'information overload' problem the 'cheddar cheese syndrome'... Have you ever looked at the varieties of pre-packed cheeses available at Tesco for instance? Take away the few exotics and you are basically left with cheddar cheese - plenty of flavours but still cheddar cheese. Last time I looked I counted more than 25 types (sad I know) - and that's only cheddar cheese, not trading indicators.

What I found with learning to trade is that you have to go through the overload process before you get the realisation that you must simplify everything. Even then, the computer and its inherent power is always pushing you to make it overly complex. Although I have a proper trading plan I found (and still do) it very useful to jot down the essence of my trading rules and philosophy on a postcard (suppose it would have been the back of a fag packet in the old days). If you can't do that then I believe it's not clear in your mind.

FTSE 100: An example of keeping your analysis simple.

In the above example we have a classic example of keeping your analysis simple.

Here, we only asked two key questions: 1) Is it trending - Yes/No? 2) What is the direction of the trend - Up, Down or sideways?

Up - look to buy it,
Down - look to sell it,
Sideways - do nothing
Next, look for support and resistance areas, trend lines and make a decision.

We have a candle chart of the FTSE100 and two lines on it - a simple horizontal support and resistance line and a simple trend line. However from these two lines we were presented with at least 5 diff erent trading opportunities. All would have been buying opportunities with only one of them failing. In each case except one, a buy order with a stop loss below the sloping trend line would have yielded a profit.

Q. Do you absolutely need to use technical indicators to trade successfully?

A: No, in fact there are some big money traders (managing in excess $10M accounts) out there who rely mainly on gut feel whilst others use very simple charts yet are still hugely successful. And some traders simply rely on price and price alone as the main indicator.

For the rest of us who aren't so fortunate I'd say it is best to stick to a few signals and also to try to choose the signals that suit your personality. It is okay to only follow one or two signals or indicators but it is important to get to know them thoroughly. You only get confused and mixed signals using multiple signals. For instance I know one trader who uses MACD and spots things most of us wouldn't see. I do the same with CCI. Even another trader mainly uses point and figure while quite a few FTSE index traders use stochastic. You can make money on any of them. Even moving averages - look for the bigger picture as the moving average snakes across the chart it makes more than just turning points. It also forms cycles with higher highs or lower highs and higher lows or lower lows. You've got to fully understand whatever indicator you decide on and stick with it. They all work up to a point and none are best in all market conditions. Flexibility is needed. You have to find what's working today and even more important what works for you.

 ...Continues here - Moving Averages and their Application

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