Learning How to Use Indicators: Five Tips To Use These Trading Tools Effectively

Technical indicators are an important part of trading because they provide valuable tools to aid us in our understanding of underlying price action. Indicators make comparisons easier and allow us to interpret information in an “easier to process” way for our brains, therefore allowing us to make better decisions and design better systems to trade the markets. However it is obvious that the large majority of traders do not use indicators properly and many new traders often fall into the category of “color traders” as they fail to have any interpretation of indicators besides some – often arbitrary – visual signal. This is what leads many people to believe that indicators simply “don’t work” and move to simpler methods of analysis. On today’s post I am going to give you five tips to help you use indicators correctly, making emphasis on what you should and should NOT do when approaching trading using technical indicators.

Let us remember – before moving onto the tips – that indicators are nothing but mathematical calculations involving either price, volume or a combination of both. Most indicators provide information based on your price charts and therefore every conclusion derived from an indicator could also be derived from price action analysis. However you will see that the convenience of this analysis becomes apparent when we use indicators and you’ll see that certain conclusion achieved through the use of indicators can hardly be achieved when using price action as the analysis becomes too complex in nature. We’ll now move onto the tips I have to offer to help you use indicators more effectively:

1. If you cannot calculate it by hand, don’t use it. When people use indicators they often do not have the slightest idea of how the indicator is calculated and therefore there is simply no idea of what the indicator’s information represents. Reading that the indicator represents X or Y within a website IS NOT going to help you, you need to be able to fully understand what the indicator’s underlying calculations are and you should be able to do this yourself (by hand). If you’re using an indicator whose output you cannot replicate by hand then do NOT use it, you don’t understand it and in the end this will only bring you failure. Use only indicators which you fully understand, which have calculations you can reproduce by hand.

2. Know what information you need. This is perhaps the hardest portion of indicator usage. Many “color traders” have screens filled with lines from indicators they do not understand because they lack any knowledge of what information they need. Realize what you want to trade and then use indicators that show you this information. For example if I want to get into trades that favor the daily trend I will look into a very long period moving average on the hourly (perhaps 200 periods) because this shows the consensus of price during the past 7-8 days which allows me to understand how things are evolving. If the consensus has been steadily increasing then I know that things are going somewhere on average. Then if I want to look for entries on retracements I could use a short period Stochastic which signals proximity to a percentage value above the low of the past X period. Know what information you need and use indicators that compliment your trading approach.

3. Do not trade anything you can’t describe in terms of meaning. Whenever you come up with an indicator based strategy ABSTAIN from describing it like a “color trader”. Saying something like “buy when above 20 and sell when below -20” is a wrong approach which is useful -indeed vital- for coding strategies but NOT for designing and understanding them as a trader. When you come up with a strategy describe it in terms of meaning. For example on the above mentioned methodology I would say something like: I will enter trades when the long term consensus has had an upward slope during the past 3 days and then a retracement comes into effect which reaches 20% above the past day’s low. This strategy is represented by a moving average and a Stochastic oscillator, the strategy is described in a way which denotes understanding but which PRESERVES precision.

4. Be precise about what you intend to do. Sometimes failure from indicator usage comes from a lack of precision in the way in which indicators are used. You should come up with indicator strategies which can be used in a way which is very precise as this allows you to evaluate your strategy across long time frames (10 years) and derive adequate expected statistics, edge ratios, etc. When you trade an indicator strategy always be precise about your usage of indicators, things such as “when there is a steady slope upwards” is very subjective and not prone to evaluation, you should change that to “when there is a continuous upside slope during 5 days”, have definition on your methods so that they can be correctly turned into full strategies so that they can be coded and simulated.

5. Do what price action analysis cannot do by itself (or at least not with such ease). Using indicators to do something that pure price action analysis can do better is not the best usage of indicators. When you use indicators you should aim to build strategies which take advantage of what price action tells you and what indicators can tell you beyond this. Indicators have the advantage of being “purer” representations of different aspects of price action so they allow you to take decisions with less overall noise. For example an RSI indicator will tell you what the net movement during the past X periods has been towards the upside, making it an ideal indicator for short term momentum determination regardless of what the actual shape of this price movement was. The most powerful thing is certainly to use both together, making them compliment each other in a way which allows you to take advantage from both conditions when there is directionality without pattern (where indicators often profit) and when there is pattern and directionality (when pure price action gets more profit and indicators usually show less advantage).

As always following my tips will not be an immediate guarantee of success but I can assure you that success will be much more likely if you follow the above steps because following them implies that you will gain an understanding of what you’re doing. Trading indicators you fully understand, building a plan based on the information you need and representing this information in a precise way are all truly necessary steps in order to achieve success through the use of indicators. Remember that indicators are a tool and your success by using them only depends on your level of understanding (not on finding that “zero lag” holy grail green and red arrow indicator).

If you would like to learn more about my work in automated trading and how you too can learn how to use indicators and price action to build trading systems 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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4 Responses to “Learning How to Use Indicators: Five Tips To Use These Trading Tools Effectively”

  1. Rimas says:

    Very true insights, thank you for your precious time.

  2. Andrea says:

    Using indicators you are following past data which tells you nothing about future data prediction.
    Every indicator is a lagging indicator. Following lagging data does not make any sense. It is a loosing strategy.
    A combination of price action and indicators and making any buy/sell decisions based on pure price action and having it confirmed by an indicator or 2, is the only way to be succesfull in trading.
    Remember, day trading and swing trading is 90% psychological and only 10% technical.

    • admin says:

      Hi Andrea,

      Thank you for your post :o) The idea that indicator data is “lagging” is simply a misconception based on the interpretation you’re giving the data. Indicators are showing you a different shade of the same information you see on your screen and therefore they are as “up to date” as the candles shown on your screen. I wrote a post about this a while ago if you would like to read further : http://mechanicalforex.com/2010/09/destroying-a-myth-indicators-lag-actually-they-dont.html. Indicators do not lag – they don’t by definition as they merely use the SAME information you use when you trade price action – what gives the impression of lagging is the incorrect interpretation of what the calculations they carry out represent (the behavior you choose to interpret as a “signal”). Understanding what the underlying calculations mean and interpreting this meaning is KEY to succeed with them. Correctly interpreting indicators (through an in-depth analysis of their calculations and what these calculations represent) can bring results as good or better than price action strategies. I advocate to use both approaches as certainly both can be used very successfully.

      The idea that indicators cannot be profitable and that trading is mainly psychological is also misleading. Indicator strategies can be profitable (I trade many and have also published many on Currency Trader Magazine) and properly executed mechanical systems that have an edge can be successful, being purely price or indicator based. Psychology is not the main problem but a consequence of lacking understanding. When someone doesn’t know the statistical characteristics of their strategies and lacks any understanding about why a strategy is successful, when its statistical characteristics have deteriorated, etc then fear and greed start to play a role. So I would say that success in trading is not psychological in nature as psychological problems arise from a deficit in understanding. I also wrote a post about what I consider the “recipe” for success in trading here: http://mechanicalforex.com/2010/09/what-is-needed-for-success-in-forex-trading-an-exercise-diving-the-necessary-skills-into-percentages.html. Thank you very much again for posting!

      Best Regards,

      Daniel

  3. erick says:

    These strategy formulations are always good to read:

    “I will enter trades when the long term consensus has had an upward slope during the past 3 days and then a retracement comes into effect which reaches 20% above the past day’s low”

    Could you write an article that lists more strategies? Maybe an e-book with a comprehensive list of strategies that are long-term profitable?

    And this is a good insight:

    “Psychology is not the main problem but a consequence of lacking understanding.”

    When you understand, how can there be fear or greed? Understanding (plus money management) is the zen approach to trading.

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