What’s your ‘favourite’ indicator and why? And why those who say they only use price action are missing other critical information..
Many in our community will read our “is the trend still your friend?” article published early every Monday morning. In the article we highlight the preceding week’s major fundamental high impact news events and the coming week’s high impact news events.
Then we begin the tricky task of predicting which way the market will move in the current week by way of: indicators, moving averages, the overall sentiment displayed by price action and evaluation of where price is in relation to what we term “looming and psyche numbers”, typically numbers such as 15,000 for the DJIA, or 13200 for EUR/USD.
Now you could be forgiven for looking at our indicator based analysis and suggesting that we throw everything in there; MACD, DMI, stochastic, RSI, Bollinger bands, ADX, PSAR, Heikin Ashi candles, but there’s a reason. Firstly we believe we’re covering most of the bases, using primarily oscillating, trend and momentum indicators. Our four groups would be;
- A trend identifying tool
- A trend confirmation tool
- An overbought oversold tool
- A profit taking tool
Secondly we’re deliberately encouraging our readers to become familiar with the patterns and behaviour of those leading indicators. Here’s a brief suggestion of how using one from each of the four sets would work;
Trend identifying tool could be the DMI or moving averages crossing, trend confirmation could be the MACD, the overbought/oversold could be the stochastic (or RSI) and the profit take could be the PSAR.
To be fair, if you look at our preceding trend analysis, we’ve had a decent record, whilst we can’t and won’t tell you where to buy and sell, the overall market advice and the indicator ‘incidents’ we’ve pointed out, have provided a decent bedrock of analysis, particularly for the newer members of our community.
What is fascinating, as you discuss indicators and indicator sets with traders, is just how magnetized certain traders become towards different indicators. For example the RSI, or the MACD. For me, if I was forced to name an indicator as my “favourite”, it would be the DMI. Particularly if the setting is adjusted it tends to keep traders in the trade until the maximum value has been squeezed out. However, its biggest ‘failing’ is that (using it on an adjusted setting) it seriously lags, the upside being that you’ll get into the trade once the trend is confirmed.
The main reason I have a ‘soft spot’ for the indicator is due to the work on it by a famous analyst and trading author named Charles Le Beau. His book on technical analysis, “Technical Traders Guide to Computer Analysis of the Futures Markets”, now some twenty years + old, really piqued my curiosity regarding the mathematical side of using indicators; trying to ascertain if there was any pattern to the randomness, beyond bullish and bearish trends, a phase that we all go through.
Anyhow, to cut a long story short Charles Le Beau came to the conclusion that only the DMI ‘worked’ out of all the indicators he had tried and bench tested. It wasn’t that I slavishly followed this advice, I simply noted that on the higher time frames (where I choose to trade) the indicator helped deliver good results as part of my overall technical analysis. Have I moved on with my infatuation with the DMI? Yes and no, for swing trading it’s still on my chart, but in many ways I tend to look holistically at all the indicators previously mentioned. Combined with Heikin Ashi candles and where price is in relation to looming round and psyche numbers, in order to make my decisions. For me that approach provides a terrific vista as a snapshot of sentiment. Oh, and I use PSAR as a trailing stop mechanism to trail price.
Price action can lead to inaction
One issue, that confirmed users of indicators will have to contend with, is what we’ve termed ‘price actionistas’ mocking the use of indicators and in many ways it’s caused many traders who favour using indicators to be slightly embarrassed by their faith in indicators. These are the price action evangelists who will constantly refer to all indicators being “useless and misleading” in equal measures.
They’ll contend that the only representation needed on a vanilla chart is price, represented by bars, candles, (be it ordinary, or Heikin Ashi) or lines. One other issue, those who favour price action only will always point to, is that indicators lag, they don’t lead. They’ll contend that as a consequence of that lagging nature you’ll miss entries. However, using price action only can harm your trading results by an unforeseen issue that many fail to debt fit until it’s pointed out, the lack of precision which leads to indecision.
Let’s use one of the most favoured price action pattern; traders using an engulfing pattern to make a decision on when to enter. An engulfing pattern on a 4 hour chart will take 8 hours to confirm, therefore it too is a lagging indicator. Indicators use historical data, therefore anything other than the tick chart, without any regard to historical price, is the only true price action. So for all the claims from price action evangelists regarding price as the only true indicator, we can clearly see that technically price action can lag by up to four hours and that a tick chart is the only reliable form of immediate price action
The other issue regarding price action is the levels of indecision; at what point do we actually enter and exit using price action? Do we simply set targets and limits, how do we possibly gauge, within a reasonable value and range, how and when to close trades by use of price action using candlestick patterns only? The fact is that (when challenged) many price action users will admit to having the RSI on their chart, or PSAR, what’s for sure is that the vast majority won’t rely on price action only, despite their vocal protestations.
Finally it’s worth checking out certain publications such as Bloomberg when they take the temperature of the markets by asking chief technical analysts from firms such as Goldman Sachs and JPM for their thoughts on where price of certain FX pairs is headed. These analysts often refer to: Bollinger Bands, Stochastics, RSI and the MACD. There’s no hint of ‘shame’ regarding their use of indicators, just the subtle admission that they ‘work’ for traders at some of the largest trading firms on Wall Street.