If you decide you want to eat healthy, produce from a farmers market could be an excellent place to go. However, just because there’s plenty of options, this does not mean you should eat them all. Some may taste better than others, some may cause allergic reactions, some may have strange smells. Even if the end goal of everyone at a farmers market is to buy healthier foods, there’s no one way to do so. Everyone will buy what is best for their own purposes, whether that be taste, smell, allergies, or otherwise.
Trading indicators should be no different. There is a camp that solely trades on price action and ignores everything else, but the vast majority employ indicators in one way or another to help them trade. However, just like the farmers market example, there is no one way to use them. The trader has to determine what works best for their own unique experience and desires.
When you look at indicators this way, your life will become so much less stressed. Even if your goal is to lose weight, there’s no holy grail of fruit or vegetables that can guarantee immediate success. Likewise, there is no one holy grail indicator that will change your entire trading career. Indicators can be beneficial, or they can become the rabbit hole that you never stop falling into. Stop thinking of indicators as magical, and start thinking about them like produce. They are not the holy grail to weight loss or other results. They are an important piece and everyone has certain types they like the best. Trading indicators should be no different.
Now that we’ve established what they shouldn’t be, let’s talk about what they should be.
Before we get into the types of indicators, let’s establish a few rules.
Rule #1. Trading Indicators
This means that when you are using an indicator as a trigger, the price itself would have already started to make the move. When you are looking for price to get over extended, it will have already done so before your indicator agrees.
When using indicators, you have to accept lag time. As they use price in their formulas, they simply cannot print until price does. Even some of the “leading” indicators still use closed price points to print future points. If you cannot accept getting in late because you waited for the signal to fire on an indicator, you may have to look and see if indicators are really for you.
Many traders think that certain indicators are leading and not lagging. The truth is that they still require closed data to print, even if they are displaced forward or otherwise, they still require closed price action to print the formula and as a result I still consider them a lagging indicator.
If anyone truly created a leading indicator, they’d print money every single day. The truth is leading indicator is just a sexy buzz word because if you could lead the market, you’d never lose. And professional traders lose constantly, they know it’s part of the game.
Rule #2. Customizing Inputs Should Substantially
Every Indicator has the ability to customize the inputs. For example a moving average takes the closing price of X number of candles and divides the result by that amount to create a line. Many traders like to use a 20 moving average.
However, once the strategy is built, traders like to run computerized tests to determine chinks in the armor or areas to improve. Once that happens, optimization becomes a problem. If your system is failing at a 20 moving average but working great at an 18 moving average, traders start to over optimize the system based on perfect results. The reality is customizing the inputs should NOT change the system itself more than 20% or it’s becoming over optimized and will not deliver those types of results in live trading.
All indicators can be customized almost as much as the trader desires. The customization should help the trader feel more confident, not change the results. It’s like a trader eating an apple vs cutting it into sections. Either the way the apple gets eaten, it’s just a personal preference. Changing inputs should be viewed the same way for 98% of the traders out there.
Rule #3. Different Indicators Can Accomplish
This rule is imperative if a trader is using a checkmark system for entry. Some traders like to use 5-7 things that allow entry when they get a majority.
The issue with this is you have to understand (which we’ll discuss in detail) that indicators can accomplish the same purpose. And if that’s the case, then using multiple indicators on your chart will not add any edge. You want your indicators to each add significant value to your chart. If we go back to our produce example, if the goal was only to eat enough fruit to get 100% vitamin C, you could eat an orange and be done.
You could also eat any combination of other fruits or vegetables to hit that goal, but if you eat them AND the orange, you may not get an added benefit if your main purpose was vitamin C. You would have been better off having a different goal for the other fruits and vegetables.
As you learn about what the types of indicators and their purposes are, you’ll soon find out which indicators are worthwhile, and which are simply overlapping and unnecessary. The key to rule #4 comes from thoroughly understanding rule #3.
Rule #4. More Indicators On Your Chart Are
Think of your chart like an expensive leather couch. You’re proud of this couch, you want to use it constantly, it’s the most comfortable couch you’ve ever had.
Yet for whatever reason, you or your significant other start adding pillows to this couch. Fancy throw pillows that help the couch work even better, look even better, smell even better. Whatever the reason, you just keep adding these pillows until suddenly that amazing couch isn’t recognizable nor usable. The pillows which were supposed to supplement the couch have taken over entirely.
Indicators on a chart should be no different. When you build your perfect chart, with all the right colors and lines, you feel like you’re in the zone. Yet some traders read a blog post, watch a video, read a book, or whatever else, and suddenly add an indicator. Here and there, they really do help. Yet before too long, most traders end up with a screen so covered in indicators it’s no longer recognizable or usable.
Don’t let this happen to you. Remember the end goal of a chart is to help you make a trade. If you can’t thoroughly explain why every single indicator on your chart is there, start taking them off. Back to our couch example, what happens when you take off all those pillows? You get to use the couch again. The same can be said of your charts.
If you want to build a separate chart with tons of indicators for research purposes, fine, do so with gusto. But your trading chart, the chart that is responsible for making decisions, requires better. Explain why that indicator is there, or take it off. What you’ll be left with is what you truly decided you need to trade. And that is a decision that no one else can make for you.
Trading Indicators Come in Different Categories
Trading indicators come in all varieties and fashions. The end results, however, tend to accomplish only a handful of things. Indicators are mathematical formulas that are based off of the High, Low, Open, Close, and Volume. These combinations along with other mathematical parts have created thousands of combinations, each named after the trader that discovered them.
Yet for all the different combinations, they function for a very few set of purposes.
Trend, Momentum, Volume, & Volatility. Many guru’s say you should have one from each category in your plan, some require that you have multiple from each. If you want to chart the CTP Way, then remember it’s your money, it’s got to be your plan. You get to decide how many and what goes on the chart, just make sure it follows the rules above.
Trend Indicators are those that help determine the trend. Trend strength is very subjective to the timeframe you are on, but when you hear someone ask what’s the trend, and you want to answer them with an answer involving technical analysis, these are the indicators to use. A few of the indicators that fall into this category are:
- Moving Averages
- Ichimoku Cloud
There are hundreds of them out there, but the majority of traders can find what they need simply using this list.
We will discuss in detail these indicators on our advanced section indicator 202. If you prefer to skip ahead, you may do so now, this link will be available at the end of this article as well.
Momentum Indicators are those the help determine the momentum of the trend. These can also be used as excellent pullback opportunities back into the existing trend. The final use of these indicators is gauging when a trend could be coming to an end by means of divergence.
A few of the indicators in this category are:
One of the most important factors in using these indicators is remembering what Livermore said, “Markets Can Stay Irrational Longer than You Can Stay Solvent.” This means, just because you’ve got an overbought signal does not mean the trend cannot keep going. Look at the general markets since 2012.
Volume is the most important thing after price. If you had to have only one indicator on your chart, volume would be it. Volume tells you when there’s a large move starting, when there’s no one left to continue, when to ignore a pullback, and when to pay attention. Many traders that don’t believe in indicators still use plain volume because it’s that powerful.
A few of the indicators in this category are:
- Volume (typically includes a 50 day average of volume to show when it’s stronger than normal)
- Chaikin Money Flow
- On Balance Volume
Volume is one of those things that some traders simply like to ignore, but when used properly, it can greatly improve the results of some of your trades. This indicator cannot be ignored.
Volatility is extremely important in trading. If you buy a stock at $10, and you want to sell it at $11, what’s the potential it will get there? If you want to place a stop on that same stock, how far away should you place it? Volatility answers these types of questions.
Examples of Volatility Indicators are:
- Average True Range
- Bollinger Bands
- Keltner Channels
- Price Channels
Volatility may sound confusing and some traders may simply want to avoid what they don’t understand. However, once you see it in action, it may become something you simply can’t live without.
Putting It All Together
Now that you know what categories indicators come from and a few types from each, take a look at your chart. Are you heavy on one category? Do you have something from each? Do you see a need to adjust?
Let’s use one quick hypothetical example before calling it a day here.
The picture shown is NVDA. We have incorporated one or more indicators from each category. The red solid line is a 50 simple moving average, the white lines are a 20 range price channel, the indicator with vertical lines that looks sort of like a cloud is called the Ichimoku Cloud, and the three indicators at the bottom from top down are volume, MACD, and Stochastics.
If we were looking for a pullback trend continuation setup, we’d want to see a combination of things confirming a high probability edge.
These indicators will all be discussed in detail in indicators 202, but for now, we are simply trying to show a finished product. We will go back and dissect each part over future posts.
From our trend indicators, we’d want to see an uptrend. This happens by price still being above the 50sma, the MACD still above zero, and price still above the cloud. All options are checked yes.
From our momentum indicators, we see the stochastics has reached oversold by getting below 20. When looking for pullbacks, stochastics needs to get as close to oversold in an uptrend as possible. Check & Check.
From our Volume Indicators, we see price spiked near the end of the run-up roughly 2-3 weeks before giving our pullback entry.
On the pullback however, there was no volume strength. A low volume pullback is an excellent sign that when price starts to turn, the trend will continue. If the volume was strong on the pullback it could be a sign that traders are getting out. Since the volume was weak however, the odds were high that there was simply no one left to buy in the short term, not that traders were exiting existing positions.
From our volatility indicators, we can see price got below it’s 20 day range. A stop below this low by a % of the 20 day range could be an excellent risk reward setup.
If the trend is to continue, a new 20 day low could become an excellent false breakdown point. Traders that only used volatility here may be tempted to fight the overall uptrend.
Traders that used multiple categories however were able to see the stronger uptrend and use this short term new 20 day low as a reason to place a high probability buy setup.
And there you have it. Four categories, four different approaches. When you put them all together, they can create something powerful.
This is what a trading indicator or indicators should do. When you dump so many on the chart you can’t read the chart, it’s time to change. When you trade just the right amount for just the right reasons, you can build a consistent and powerful edge.
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