Technical Indicators : What They Tell You and What They Don’t

One of the things I believe people find the most confusing when they start to get into forex and trading in general is the use of technical indicators. At first, people read and are told that indicators are used to “forecast” price action but after using them and trying to develop systems with them for a while people realize that indicators “lag” and are not able to predict the future direction of the market. The problem is that people are not understanding what indicators are telling them and what indicators are not able to say this in turn leads to a “disappointment” regarding indicators reason why many people start to believe that “indicators do not work” and that direct analysis of price action is the only thing that may be able to yield a reliable trading tactic. Within this article I am going to explain why people’s normal usage of indicators is wrong and what I believe is the best way to understand and use indicators.

Usually new traders believe that indicators are supposed to forecast future price action. They tend to believe that an indicator should reach a or b or change color and this should lead to a given movement on the market. What people find is that indicators tell them about the movements in the market after they have happened and therefore they “lag” price action. This approach to indicators is actually not correct. As a matter of fact, indicators do NOT lag the market, they simply lack any capability to represent the future and they merely give you information about the past. For example, let us look at the following chart of the Stochastics Oscillator :

I have highlighted several important points of this chart which are usually used as entry signals by new traders. However, if you take into account the mathematical aspects of the indicator and you take into account what the actual math is telling you, you will realize that the indicator is only giving you information about past price action. Why should you open up a short trade if the stochastics oscillator reaches 80 ? Why is so important about price action reaching 80% of its previous X period range ? If you see, the attempts to predict future market movements from indicator values come from our interpretations of the indicators, the indicator itself is not conveying any information about future price action.

When a person understands how the market works it allows him or her to take advantage of indicators in the sense that they will let the person know when certain events which may lead to another event in a statistically significant manner happen. For example, when using the stochastic oscillator a person who understands the math behind the indicator will recognize that a suitable strategy to enter trades upon trend retracements can be deviced. For example, if a longer period stochastic oscillator reaches a high value (70-100) then this means that price is moving at the top of the range, meaning that we are probably in an uptrend. Then, when a shorter term stochastic oscillator reaches (0-30) it means that a retracement of the longer term up trend has happened and an entry to follow the trend can be made.

Trading with indicators is all about understanding the information they are giving you and using it to take advantage of market inefficiencies you are already familiarized with. Indicators are good at helping you see things which have happened and help you take action when you know that a certain event will lead to another with a good probability. The above example shows how one can use the stochastic oscillator to enter a trend on a retracement something which is bound to lead more towards a trend continuation than a reversal, which is why such a signal is bound to have a positive mathematical expectancy.

As you see, many people believe that indicators fail because X or Y signal does not work for them but what they are failing to understand is that the success of indicators depends entirely on the understanding a person has of what the indicator is saying and how this knowledge can be applied to exploit a tradable market inefficiency. When you can understand what the indicator tells you it will be easy for you to use this knowledge to device a sound trading strategy which you can efficiently follow.

If you would like to learn more about sound trading tactics and how you to can learn to design and program your own adaptive long term profitable automated trading system please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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