If you have traded for long enough, you have probably found yourself discussing at some point the issue between price action and technical indicators. Some traders – after a long battle with indicators – find a sense of elegance and simplicity in price action analysis while others argue that indicators provide for information that cannot be obtained from simple price action. Is there a fundamentally better way to understand the market? Is there any advantage you can get from using price action? Is using indicators a way to ensure that you only produce systems that work in hindsight? On today’s post I seek to answer these questions as well as give you some clear facts regarding both price action and technical indicators. We’ll go through the definitions for both, how they are different, how they are the same and how these characteristics might relate with actual trading and profitability.
Let us start by defining both concepts. Price action is generally defined as any interpretation of the market that arises from simple comparisons of raw market data. For example if your trading system compares today’s open with the close 10 days ago then you can say that you are currently trading a price action based system. Price action strategies do not process raw market data in any way and therefore provide the purest image of the market. Technical indicators, on the other hand, process raw market data in some way that may eliminate some information contained within the original data. For example a stochastic oscillator gives you the location of current price relative to the High/Low range for the past X periods and in the process it reduces all market information to a 0-100 range. Technical indicators go through data and return values that are an overall simplification of the underlying price action. You could view price action as a loss-less way of trading while technical indicators are a filtered way of trading.
From the above it could be easy to say that price action is better because it provides more information. However, the amount of information in the market that is relevant for predictions is small, as the market is incredibly noisy. For this reason technical indicators provide a level of filtering that can be very useful in deriving systems that generate signals based on the actual underlying market behavior that is interesting to us, rather than the noise that is above. Indicators become more useful as the amount of noise in price action becomes larger (as time frames go lower) while they become less useful as the amount of noise becomes less. While a price action based system may have a very hard time producing viable signals in a lower time frame, a strategy based on technical indicators may be able to derive better results by simply looking beyond a lot of the noise that makes price action trading harder.
The above also does not mean that technical indicators become irrelevant as the time frame becomes larger. A technical indicator can provide you with information that is difficult to see across large amounts of data. For example a technical indicator might be able to show you what percentage of the past X bars where bullish or bearish, something that is difficult to deduce from simple price-action based comparisons. This also does not mean that price action is irrelevant at low time frames as price action can often react quickly to some events that are difficult to see through indicator filtering. While an RSI filter might take some time to react to a market spike, this can be caught very rapidly with a price action based strategy that is making some quick OHLC based comparisons using data from only the past few bars.
From an algorithmic system creation perspective people often complain against technical indicators because they are perceived as being more prone to “curve-fitting”. People often think that their chances of developing a successful strategy with indicators are slim because the degrees of freedom inherent to the indicators themselves – the variables relevant to their signal processing – gives them the ability to adjust the system (curve fit it) to past market conditions in what is perceived to be “excessive”. However price action based systems can do exactly the same thing if they are provided with enough degrees of freedom. A trading strategy based on 10 price action based rules can actually be more prone to being “curve fitted” that a strategy that is developed using a single indicator with 3 filtering variables, simply because the price action based strategy has more degrees of freedom. The issue here is related to the data-mining bias of each one of the two approaches, provided you have determined your data-mining bias for whichever number of degrees of freedom you have there is no inherent advantage or disadvantage inherent to the type of system you’re using. The issue here is related to the degrees of freedom of your strategy and not to the type of variables being used.
It is also worth mentioning that I have had experience in the past with both types of trading strategies (based entirely on price action and entirely on indicators) and I haven’t found any indication that one source might be better than the other. A strategy can be developed in an entirely sound way for any of these two approaches and neither one nor the other gives the strategy an additional probability to succeed under live trading conditions. In the end both price action and indicators are sources available for the design of trading strategies and a smart trader would definitely take advantage of both to develop better trading systems. Indicators can be used as signal filters to get information that would otherwise be difficult to get, while price action can be used to provide additional confirmations, fast reacting exits, etc. Both of these sources have their uses and they can indeed be combined to arrive at a more holistic approach to trading.
Finally I would like to point out that it is very important to understand indicators whenever you use them. Indicators are signal filters and as such you should understand what they are filtering, what information they are giving you and how you can use this information to create or improve a trading system. Indicators can rarely be used successfully without a deep understanding about what they are calculating, how they are being calculated and what these calculations say about the underlying price action.
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