The Homework Corner : Understanding the Purpose of Indicators – Assignment No.4

When new traders are introduced to technical analysis one of the first things they look into are ways in which they can obtain profitable “signals” to trade the market. The most basic way in which this is attempted is through the use of technical indicators by following certain rules which are supposed to bring long term profits. Things such as “go long above 20” or “go short when price crosses the blue line” are typical rules of this sort of endeavor. This type of traders are usually referred to by more experienced ones as “color traders” because they lack understanding and simply use visual signals to enter or exit trades. On today’s homework assignment I want to teach you about the correct way to use indicators and build trading systems using a series of simple exercise so that you can realize what the correct usage of an indicator actually is.

This week’s assignment will give you some very important insights into the usage of indicators and will let you better understand what the nature of indicators actually is and how they can be used correctly. In order to perform this homework please follow the steps highlighted below :

1. Bring up a 14 period RSI indicator on any trading instrument you want (1 hour chart), now look back historically for the past few days and locate cross levels which seem to “signal” profitable trades (for example when the blue line crosses above the 30 level from below go long).

2. Now locate the places before these entries which you would have considered “ideal”. Take note of how far behind the indicator signal they actually are.

3. Search online for the formula for the calculation of the RSI and manually calculate the value of the RSI for the last 3 bars of your chart.

4. Do the above same exercise for another indicator of your personal choice (choose from the traditional indicators included within MT4).

After you have finished the above homework you can now answer the below given questions so that you can better understand the way in which indicators work :

1. Was most of the time the “ideal entry” you considered very much “behind” the indicator signaled entry ? Why do you think this is the case ?

2. An indicator uses price data to calculate its values and therefore it is just an additional interpretation of the information on your screen. If this is the case then why – if there is a lag – does it exist ?

3. Try to phrase the entry criteria you chose in terms of the indicator formula instead of just “cross above X level”. For example a long entry based on a 200 and 50 moving average cross could be thought of as an entry when the consensus of price through the past 50 periods is greater than the consensus for the past 200 periods, meaning that the consensus of value is increasing over the short term. Does your perception of the indicator signal change when your phrase the entry this way ? Why and how ?

4. After rephrasing your indicator signal in the above mentioned way do you think that the information is different from the information on your screen ? Explain your opinion.

5. Is the generated indicator lag – if any – a perceived artifact ? Is there any way – even when looking at non altered price action – in which you could predict the future ?

Although the above homework and questions will not provide someone with a complete understanding of indicators the above exercise does show some of the most important facts about the usage of indicators which pertains to the way in which the trader relates to the displayed values. When simply looking at the screen – lacking understanding – indicator signals and values are interpreted in the wrong way while when understanding arises a complete and overall sound interpretation of indicators based on their representation of price action actually comes to play. The above exercise leads you down this road, attempting to teach you through a practical exercise the in-depth differences that materializes when indicators are considered from an uneducated or educated perspective.

If you would like to learn more about my work in automated trading and how you too can learn to understand indicators and their successful use in algorithmic system creation please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)

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