Why simple works in indicator based trading where complex often fails…

Nov 20 • Between the lines • 4220 Views • 3 Comments on Why simple works in indicator based trading where complex often fails…

blackboard-graphThere is an inevitability, once traders begin to discover trading indicators, that they’ll begin to experiment with many (if not all) of the recognised most popular indicators. Perhaps they’ll start with one indicator, such as the MACD, and begin to add layers upon layers of indicators onto their chart. Then they’ll begin to adjust the settings on some of the more popular indicators after watching price ebb and flow on their charts over a set period of weeks. They’ll inadvertently ‘curve fit’ the indicator settings on their charts, in order to match precisely where price has turned and where sentiment has changed from bullish to bearish.

One of the next inevitable stages a trader will experience is adding other metrics to their ‘heavy on’ indicator charts; trend lines, moving averages, Fibonacci retracement levels, support, resistance and the daily pivot line. The trader will also experiment with all the different time frames, from tick charts, to fifteen minute, one hour, four hour, daily and perhaps up to weekly charts, all in pursuit of the continually out of reach ‘Holy Grail’ of trading; trying to find a method that has a close on 100% success record, which doesn’t exist.

There will be many experienced traders who will read the previous paragraphs whilst looking through their hands as they feel crushed by embarrassment as they recognize the journey we’ve outlined. However, they shouldn’t feel embarrassed, they should feel empowered that having put themselves through the usual initiation ceremonies, they’ve eventually arrived at a situation where they’re proficient and profitable and as such no longer need to have so many indicators and reference points placed on their charts.

 

Less is more

But there are traders, who having experimented with all the possible indicators, continue using a cluster of indicators as indicators appear to fit their trading style. We’re fond of stating that “less is more” in trading and by effectively using certain indicators on a higher time frame (such as the daily time frame) many traders find a method that suits their trading style and overall strategy. In the rest of this article we intend to highlight a couple of indicators and illustrate how using them as part of the simplest trading strategy traders could imagine, with slight adjustments to their standard settings, can allow traders to follow price and occasionally see their indicators lead as opposed to lag, that state of behaviour many traders, experienced and inexperienced search for.

 

RSI; the relative strength index

RSI is an extremely popular momentum indicator. Developed J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally and according to Wilder, RSI is considered “overbought” when above 70 and “oversold” when below 30. Signals can also be generated by looking for divergences, failure swings and centreline crossovers. RSI can also be used to identify the general trend.

The standard setting of the RSI is 14 and many traders add another level to their decision making we’re the RSI is concerned by noting when the RSI line crosses the median line of 50. They not only look for the overbought zone to be a reading above 70 and the oversold zone to a reading below 30, they look for the key median line to be the dividing line between bullish and bearish sentiment. Traders may also consider adjusting the standard setting of the RSI from 14 to lower settings such as 9 and 5…

Flipping the polarity of the RSI on its head by using a setting of 5 can give a completely different reading and allow an alternative use to that which has become widely accepted. For example, traders may adjust the setting of the RSI to 5 (a five day period) and plan their trades on a daily chart. The trading concepts we’d then use would be entirely counter intuitive to the initial purpose and invention of the RSI. Our trader would enter long when the RSI breached the 70 line and go short when it breached the 30 line. Our trader would immediately close the trade when the RSI line re-crossed the 30 and 70 in the opposite trend direction.

 

Stochastic Oscillator

Developed by George C. Lane in the late 1950s, the highly regarded Stochastic Oscillator is a momentum indicator that defines the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane, the Stochastic Oscillator; “doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.”

The standard settings of the stochastic two line indicator are 14,3,3, however, trend traders often slow the stochastic down to 10,5,5 on a daily time frame. This setting often appears to lead price; in as much as any indicator can actually ‘predict’ price. This smoother, less erratic setting, appears to ‘dial out’ false readings and indicates the development of strong trends. The note that the inventor of the indicator suggested; that it follows the speed or momentum of price, appears to work extremely well on this setting and whisper it quietly there are many trend traders in institutional trading environments who use this setting.

 

One indicator on a chart, can it work?

Of course it can is the simple answer, as part of a trading plan with the usual consideration given to risk and tight money management. For example, if we removed price from a daily chart and relied only on the stochastic indicator on its adjusted setting of 10,5,5, we’d quickly discover    that the indicator (on this setting) does appear to lead the turn in sentiment as opposed to lagging, which is always the most widely held critique of indicators.

Now we’re not suggesting that traders should remove everything including price from their daily chart and rely on stochastics only, what we’re illustrating is that breaking down the movement of price, into simple components using the simplest of indicators, can work. Despite all the complication and all the sophistication involved in trading it’s often the obvious solution that is overlooked, perhaps it’s time to revisit indicators with an open mind as to their use and capabilities.

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