The Truth about Technical Indicators

I've been reading a lot of posts on FF by traders who regard the use of technical indicators as flawed or fallacious, the "cause" of their losing trades and possibly large sums of money, even their entire accounts. Some posts have been rather elegantly composed, their authors expressing quite clearly their disgust, distrust, and even despair when it comes to the use (or more precisely, misuse) of technical indicators in their trading logic (or more precisely, illogic). Moreover, some of these traders, having tossed technical indicators away as a reliable means of price prediction, become evangelists for something they call "price action," part of their convictions based on the notion that technical indicators somehow fail because they are "lagging," while the so-called price-action is up-to-the-moment and an infinitely better barometer of market sentiment.

However, the real reason why they love price-action is because by embracing it (and trading completely "naked," religiously keeping their charts free of any technical indicators), they have managed to transform themselves into consistently profitable traders, almost overnight. Thus reborn, they become fervent missionaries who spread the gospel of price-action with evangelistic zeal, seeking to convert the masses who are lost and losing, who are still under the blinding spell of "worthless" technical indicators.

Every trader has his own unique persepctive of the market and how best to profit from it. (As someone famously said, "The market is all perception.") But when I see someone trying to use a hammer on a screw, or a screwdriver on a nail, I cannot help but at least attempt to offer a few suggestions based on what I know about hammers and screwdrivers. Thus, the purpose of this thread is to explain how technical indicators can be useful (and even invaluable) tools in making good trading decisions. In the coming posts, I will try to explain how I use technical indicators in my trading, and to demonstrate how they can be instrumental to consistently profitable trading. Personally, I have no shortage of consistently profitable methods which are based entirely on the usage of traditional technical indicators, so I can vouch for their efficacy from an experiential (and not just theoretical) perspective.

If you use it, any chance you can start with your take on the CCI, it tends to be one of my favs.

Interesting thread and a excellent post. I am one of these traders who has chosen price action as I have experienced it is more profitable then indicators. I will look forward to your demonstration.

Hello,

I do find your thread very interesting.

I use (my own) math based platform to calculate possible traiding opportunities (what it does simply is try to open positions at given points, on historical data, and than establish the earning capacity/potential of those positions).

So far on my platform I have implemented approx. 20+ indicators, and only 2 price action models. The idea is an indicator / price action analiser provides "signals" at certain points.

Both of those types of signals are far superior to random selected points.

The price action models signals are in general strongly superior to the indicators signals. I will in the future implement more price action models to see if this tendency continues.

In short - price action models have stronger predictive power.

If you are interested in more detailed results, I will be happy to provide some.

i also prefer price action than indicators that dont know what the market will do in the next second.

Thank you all for your kind responses so far, expressing interest in my humble perspective. I see that the thread has already attracted some confirmed price-action advocates, and let me be the first to say that my intention for this thread is not in any way meant to discount your style of trading. Quite the contrary ... if what you call "price-action" is working for you, more power (and pips) to you! (I myself use many of the same tools you do to great profit!)

Rather, my intention is to help elevate the somewhat depressed esteem some of you have toward the use of techincal indicators in general, as though indicators are somehow 2nd class citizens which have less value than "price-action". And, I want as much as possible to avoid getting into ego-contests regarding which is the best approach (as I notice many of the threads on FF eventually degenerate into). Every tool has its place and purpose, and the best traders know how to use the right ones in the right circumstances.

First of all, I'd like to get a matter of semantics out of the way. Technically speaking (sorry for the pun, ha ha), there are only two categories of market analysis: fundamental analysis and technical analysis. Put most simply, the essential difference between the two is price. If you're basing your trading logic on price (for example, anything on a price chart, including patterns, trendlines, channels, support/resistance levels, candlestick formations, pivots, moving averages, oscillators, or any of the myriad other mathematical derivations of price, and yes "price-action"), you are using techincal analysis. If you are using any other basis for a trading decision that is not based on price (for example, news, sentiment reports, economic forecasts, interest rates, what Bernake or Trichet says, Nostradamus, the Zodiac, etc.), you are using fundamental analysis. So, when someone says "I use price-action, not technical indicators, for my trading decisions," he is contradicting himself. Price-action is a technical indicator, and all technical indicators are based upon price-action. If you use price in any way in your trading decision, you are by definition using techincal analysis. Indeed, mathematically derived technical indicators were invented simply to help quantify price-action (that is, what is happening to price).

Another point of clarification: there's nothing "lagging" about technical indicators, from my point of view. The value of any mathematically derived indicator can be expressed as an up-to-the-moment value, for example, the instantaneous value of a moving average (or CCI or RSI, etc, etc) of an incomplete price bar. Besides, for those who look for a pin bar or an inside/outside bar formation (which are popular "price action" formations I notice being mentioned a lot), you still have to wait for the complete formation of those bars/patterns to fully form before they can be declared a valid bar-formation. It could be easily argued that a pin-bar is thus more "lagging" than a mathematically derived indicator, since there's no such thing as an "instantaneous pin-bar," only one that has fully formed, requiring a solid closing price to validify its existance, whereas the value of a moving average (or any other mathematically derived indicator) has a very real, instantaneous, calculatable quantity for every single tick that passes by in real-time, without the requirement of a bar's close. So, there's nothing inherently lagging about a mathematically derived technical indicator's value in and of itself.

The term "lagging" is more properly used to describe certain usages of technical indicators to generate trading signals, for example, the classical cross of 2 MA lines of different periods, or the cross of the stochastic main and signal lines, etc. Yes, in this sense, using technical indicators in this manner can be described as "lagging", because these trading signals may occur after price has already headed in a certain direction. (The indicator signal trails price, hence the signals "lag.") But so what? As has been pointed out above, pin bars or IB/OBs or double-tops and head-and-shoulders formations and support/resistance lines and trend lines and channel lines and Fib levels, and all the key "price-action" set-ups are all "lagging" in the same sense, since time must pass before these formations can form and be identified as legitimate "price-action" structures. Indeed, in certain cases, signals from mathematically derived indicators can occur well in advance of "price-action" formations which show comparable signals.

My purpose here is not to provoke a debate or argument about semantics, but to help clarify that the buzz-words with rather negative connotations often thrown against traditional technical indicators in many threads I read here at FF are really not valid when carefully analyzed. In summary, we all use technical analysis if we use anything based upon price to make our trading decisions, and whether our trading signals come from using a mathematically derived calculation of price or some pattern or formation or level that price-action produces on a chart, they can all be "lagging," in the truest sense of the word.

More soon. Happy trading to all.

Hi ForexPower, excellent post!
I am enjoying your views on Forex analysis.
Would you be so kind to post some example of how you use and combine your indicators?
One of the biggest issue I had while using them is the entry, whilst for a pattern I wait for a 50%fib, a breakout or a candle open/close, with indicators I never felt like I was getting it right even agreeing that they are price action indicators.

Indicators are a complete waste of valuable analysis time. They are designed for the lazy and promoted by the trading community as a means for new traders to jump in and think they have an expert analysis tool....so they spend money and open accounts. We should all use our God given talents for trading and God did not make indicators. (I hope )

The CCI is a great example. If you would just take a chart and convert it from bars, candles to a line chart. You would see the CCI. It is nothing but price as all indiators are.

I think that's what Forexpower is saying.

oh

Thanks again to your responses and continued interest. I appreciate all of the views and opinions expressed.

Yes, cesare76fx, I appreciate your interest, and in due course, I will present some of my own trading systems based upon technical indicators, but of course, if I merely lay out recipes ("Do this when indicator A has this value, but not if indicator B had this value within the last N bars, set your stops here, take your profit there, etc."), I would be guilty of doing what many presenters of some trading-methods are doing: dooming otherwise innocent traders to failure (which DownRiverTrader rightfully frowns upon).

So, my present purpose is to lay a solid foundation behind why I use my chosen tools, and if readers are able to really comprehend this larger, more important message, they won't even need me to spell out my specific model details ... they would be able to easily construct their own consistently profitable models. After all, trading is an intensely personal activity, and no two trader views or trades the markets in the same way. We all personalize what we learn based on our own perspectives and experiences. Indeed, two traders can have totally different ways to trade, and they can still both be net profitable at the end of the day (though, of course, at the expense of others). That's what makes a market after all.

So, bear with me for now ... hopefully I will be able to first share some vital concepts which will serve you much more bountifully than the relatively mundane details of specific trading models (of which there is no shortage in other threads at FF, afterall).

First and foremost, I must state a fundamental aspect about price, something which many traders don't fully appreciate, and yet it is what drives any and all markets, indeed, all of capitalistic economics.

It is simply: Supply and Demand.

Price can do only 3 things: 1) stay the same, 2) go up, or 3) go down.

These 3 possible price actions depend soley upon the balance between supply and demand. 1) If supply equals demand, price stays the same. 2) If demand exceeds supply, price goes up. 3) If supply exceeds demand, price goes down.

Put another way, if there are 100 buyers willing to buy a lot of EUR/USD at 1.5600, and there are 100 sellers willing to sell a lot of EUR/USD at 1.5600 (let us disregard the spread for this simple example), then price will stay at 1.5600. But, if at this price level, there are 101 buyers versus 100 sellers, then after the 100 buyers have bought from the 100 sellers, the 1 remaining buyer must increase his bid to purchase from the next available seller at a higher price above 1.5600. Thus, the price of EUR/USD goes up until that buyer finds a seller willing to sell to him at the next available price, whether that be 1 or 100+ pips away. (And vice-versa for the case where there are more sellers than buyers, causing price to go down.)

(I know this is very, very basic aspect of the market, indeed, the only real driving force behind price activity, but I seldom see it mentioned by those who describe their trading systems.)

Clearly, when you take a long position, you want prices to go up afterward, and when you take a short position, you want prices to go down afterward. Only in this way will your trade be profitable. But when you enter your trade, does your trading logic include any consideration of the basic reason why prices move at all ... that of the balance between supply and demand?

Really think about it!

It stands to reason that if your trade has any chance of being profitable, you must enter it where the imbalance of supply and demand is in favor of your trade (supply exceeding demand for shorts, demand exceeding supply for longs). Even if you subscribe to the conspiracy theories of "price manipulation by the big-boys" or "stop-hunting," the movement of price from one level to another can only exist if supply and demand are not in balance at the original level.

Knowing this, our goal as technical analysts is simple: use tools which help to indicate at which price-levels supply and demand are most out of balance, because it is only at these levels where prices will most likely move in a direction favorable to our trades. This should be the main purpose behind using any technical indicator, whether mathematically derived from price, paterns/lines drawn on a chart, or price-action itself. Such indicators "work" only when they're able to accurately indicate where supply and demand are out of balance in a direction favorable to your trade.

More soon. Best of trading to all!

Interesting points, wish to hear more from you soon.
Thank you.

Good to see another of your post.
I couldn't agree more! Unfortunately Forex lacks of real Volume indicators, I mean the actual contract Volume and not the simple volatility volume we get on MT4 with {CTRL+L}. I saw once a Delta indicator that analyze contract Volume on index and could be used on such indexes like the $, £ and Euro, to get a grasp of the demand and supply, in contracts, that you describe.

What else would you use, in conjunction to many other technical aspect, to get a clue on the strongest side on supply and demand? RSI maybe...?

Indicators are just 1 tool....if you rely on only 1 thing to enter trades you will get eaten for lunch......I love it when an indicator is on my side, but never enter a trade solely based on the indicator.....I believe price action is more important than an indicator and is the basis for entering quality trades, but you better have something more than just price action also.....I get a kick out of the guys using 3 oscillators and being impressed they are all saying the same thing...well of course the are...they are all oscillators and count as 1 trade conformation...NOT 3

Are you all familiar with this thread?:

http://www.forexfactory.com/showthread.php?t=68181

I suggest you all have a read through it. The whole thing, that is. Don't just read parts of it. It is a good thread with zero speculation and 100% definitive facts.

I have been trading actively for approximately 5 years now and its my belief that Indicators are an invaluable tool for guaging when markets are over bought or oversold. As a matter of fact isnt that pretty much what its all about, when the markets overbought its time to sell and vice versa. Of course the other big thing is timing, right? This is not the only tool I use. I rely heavily on pivot points, monthly weekly and daily, fibonacci levels as well as multiple time frames to guage entry an exits. I believe there are a zillion ways ways to trade and believe it or not every one of them is right. The key is finding / developing one thats right for you.

My mentor was the best all round trader i have ever met. He used a combination of indicators and price action. However, the majority of his profits were from indicator based systems, which he developed and constantly adjusted to adapt to the changes in the market environment and backtested with live funds. Our institutional fund was very successful to the end, when my partner retired. Today, I am primarily a price and pattern based trader and have limited use of indicators. I also integrate alot of fundamentals, as i use IR differentials within the managed program to capitalize on the carry.

The objective is to find a trading regime that suits your cognitive aptitude and personality. To extract money from the market requires one to merge their own personae to that of the market environment, regardless of how you do it. I also support that one should explore the spectrum of approaches to the market to ultimately define your own methodology and independent thinking.