Discussing various trading methods and strategies with fellow traders, can prove to be a fascinating and enjoyable exercise. Many of us more experienced traders, will enjoy conversing with novice traders, who think they’ve discovered the infamous holy grail of trading. We don’t engage with them in order to indulge in some form of righteous smugness, instead we genuinely want to help novice traders avoid the obvious pitfalls and mistakes many of us have made, which can lead to unnecessary wasted time and lost money.
You may recognize the pattern (and we’ve all been through it at some stage), during our trading metamorphosis, as we move from wide eyed innocence, to narrow eyed cynicism. It starts with the trader being convinced that they’ve discovered a unique combination of technical indicators which, when they align in perfect unison similar to a star constellation, provide the perfect trigger for us to take our trade and enter the markets. The novice trader will at this stage ignore any thoughts of: stops, risk vs. reward, targets/limit orders, leverage, used margin etc. their concentration will be solely fixated on the strategy part of the process, providing the nudge to take the trade.
There is absolutely nothing wrong with this part of our journey towards trader enlightenment, as experimentation is an essential part of our learning process. Experienced and successful traders will retain the humility to recognize the signs and remember that during their early years, they all endured the trials and errors which indicator based strategy trading methods can inflict. Moreover, many forex traders have created incredibly robust strategies, built principally on the foundations of indicator based strategies; quite simply they (indicators) can and do work.
Mistakes to avoid when trading with indicators
However, the most glaring mistakes fledging traders make with their use of indicators is twofold. Firstly; they use them incorrectly by using them to identify market behavior which is contrary to the indicator’s principal use. Secondly; they alter the settings, usually during back testing, in order for the backtest to curve fit the swings or daily trends, in order to deliver the positive results the trader is hoping to experience. Both miscalculations when added to poor trading method, can completely corrupt the potential results. An example of the incorrect use of indicators can be exemplified by watching traders use the PSAR.
The PSAR is a technical indicator that was invented by Welles Wilder for the purpose of discovering reversal points in trending markets. If price is below the PSAR, this will be indicative of a continued down trend, as lower lows are created. When price is moving higher the opposite is true. As used as a stand-alone method of trading, the parabolic indicator is a technical analysis strategy that uses a trailing stop and reverse method called “SAR,” or stop and reverse, to determine (potentially) excellent exit and entry point.
The parabolic stop and reverse indicator (PSAR), when used in its correct form, should provide an ideal method by which traders can move their trailing stops in line with the trend, whereas most traders only use it in a blunt format; dots appear above price, then go short, dots appear below price go long. Now whilst such a basic interpretation is not wrong, it’s not the correct use of the indicator and as such it’s not being using to its full potential. If used singularly, then as price turns and the PSAR indicates a potential turn in market behavior and sentiment, we can experience many inconsistent and what some would term “false” signals. We can trade the turn and find that we’re suddenly shaken out of the move, as a swing in direction can often take on an inconclusive pattern initially. This is why many traders will consider combining using other indicators, in order to confirm direction and market signals.
The other key mistake many novice traders will make when using an indicator such as the PSAR, is they’ll alter the settings and they’ll do it using recent backtesting of similar market moves, that there’re looking to trade if they reappear. This curve fitting by altering settings can be highly destructive as there’s no guarantee that the pattern which worked perfectly historically, will work in the future.
It’s important that we don’t place too much faith in an individual indicator, instead recognizing that a combination of indicators will deliver a more comprehensive snapshot. It’s also essential that we do not confuse the use of an indicator; if it generally represents a change in momentum then use it as such. Finally, leaving the indicator on the standard settings recommended by the creator of the indicator is imperative, as fine tuning it to fit historical movements is no guarantee of its future delivery. What is essential is that we remain consistent in its use and that we don’t alter the settings, in order to curve fit historical results.
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