11 Jan, 2013
Ever wonder why traders have a bunch of fancy, colorful lines and waves moving around on their charts when they look at prices? Those colorful gadgets are indicators. They help traders find underlying patterns in price. But what are indicators exactly? Essentially, an indicator is a mathematical formula that serves to derive a specific exploitable pattern in price.
Prices are always moving and traders who trade only based on the behavior of price movement are said to be price action traders. They recognize and take advantage of patterns in these price movements. Some of the patterns that price makes are openly recognizable with a little skill, but some are hard or even undetectable to see with the naked eye. Let’s take momentum for example. Momentum is just a fancy word that the markets use to explain the strength of direction that price has. Strong bullish momentum means that there is a heavy flow of buying in the market at the moment. Momentum is a specific characteristic of price that is hard to gauge using price action alone. When using indicators, however, momentum changes are much easier to spot. The reason for this is that indicators can compare the current market price, with past market data, and infer relationships and discrepancies in the comparison of past and present.
One of the most famous, if not the most famous, indicators of all time is the Moving Average. The moving average takes the average price for a given period of time and prints it out along with price. This helps traders ‘smooth out’ price action, resulting in clearer trend and directional signals. Now there are many different types of moving averages: Simple, Exponential, Weighted, and more. The difference is in the method of averaging prices. Simple, for example, gives equal weight to each price, whether it was price from 20 days ago or from yesterday, Simple moving average does not care. The exponential moving average however gives greater weight to more recent prices. This makes the exponential moving average more responsive to current data, as today’s data has much more of an impact than data from three days ago. Regardless of which moving average we use, or any indicator for that matter, the basic point remains the same – we are representing price in a different way in order to find some sort of repeatable behavior that can then give us buy or sell signals to trade with.
Indicators are neither good nor bad, all that matters is the way you use them. I have two main pieces of advice when it comes to indicators:
- Do not use to many indicators.
- Fully understand each indicator you use.
When we use too many indicators our trading screens get cluttered, which hinders our ability to make intelligent and coherent decisions. Because there are so many indicators giving us so many different signals, we begin to doubt ourselves and we no longer know what to listen to. My advice is to keep your trading screen as well as your trading strategy as simple as possible. Make sure that you absolutely need the indicators you are using before you add them to your charts. This brings me to my second piece of advice for you.
Know your indicators. When it comes to markets, there is a lot we cannot control, like the direction of price for example (too bad, right?). One of the main things we do control is our plan. Your trading plan is your road map, your rock in the ever changing sea that is the market. So do yourself a favor and know your plan. This includes understanding intuitively the indicators you are using. Do a little research and find out what the mathematical formula is for the indicator you are thinking of using. Look how the indicator behaves historically. See how it behaves in low volatility versus high volatility. Basically, test it as much as you can, to the point where you can explain its purpose to my ten-year old cousin. If you can’t do that, then chances are you still haven’t grasped the nature of the indicator you are exploring. In that case, what is it even doing on your chart?