The Practical Use of Technical Indicators in Forex Trading
06/24/2010 12:01 am EST
After having just spent six days in a classroom with a brand new group of professional forex trader students, memories of my own experiences in the class have come flooding back to me. I distinctly remember how I felt when I was learning all about support, resistance, and trends, and as the pieces of the puzzle slowly started to fit together. Now that I am on the other side of the room, I use my own experiences to teach my students in the most practical manner that I see fit, hoping to simplify the complications and frustrations of forex trading into an approach that is easy to understand. This tactic begins with keeping things as simple as possible in an effort to show novice traders the key aspects of trading consistently, and when these basics have been digested and understood completely, we then move onto the finer arts of technical analysis.
Towards the end of the week, I introduce the students to a variety of technical indicators, including MACD, RSI, and stochastics, showing the class how these tools can be used practically in a variety of market conditions. However, I also clearly explain the dangers of the indicators as well, so as to make sure that they don't fall into the same traps that the majority of other market beginners succumb to. In the world of technical trading, it truly fascinates me just how much importance people place on indicators, mainly because they don't actually understand them. In the search for the perfect prediction tool, the novice usually goes from one to another in a desperate attempt to increase their success rate and earn more money from the market. What they fail to understand, however, is that indicators are very far from the be-all and end-all of consistently profitable trading. My message for this article is that we all need to remember that any technical indicator is nothing more than a decision support tool, rather than a decision-making tool.
No matter what your indicator of choice may be, each and every one has one simple thing in common: They are all a derivative of price itself. All indicators are created with the data that price itself provides and are only going to give the trader a buy signal after price has started to rally or a sell signal after price has already fallen. This creates a potential trap for the newbies as it forces them to buy late or sell late, often missing the move and resulting in another loss. Instead of just relying on the indicator to tell us what to do, we can instead focus on the behavior of price and use the technical tool as a further confirmation vehicle to build our confidence in the position we have taken. For this example, let's take a look at some recent intraday action on a five-minute chart of EUR/JPY:
For this example, I have attached a slow stochastic indicator with its basic default settings. As you may already know, the upper and lower green lines at 80% and 20% represent conditions of overbought and oversold, respectively. Should the stochastic cross into and leave these areas, we are given buy and sell signals for trade opportunities. Notice how between 15.00 and 19.00, we had three failed sell signals before the true signal just after 19.00. Even though the indicator was saying we should sell, the market continued to rise. Again, we then had another two false sell signals—at 6.00 and 8.00—the following day before the third gave us what we were looking for. And it wasn't just on the short side either. Later that same day, we had two incorrect buy signals from the indicator between 12.00 and 14.00 before the third gave us the real deal. Now, one could argue that eventually, the stochastic did work to the trader's advantage, but before this happened, we would have to have endured a string of stop outs in the process, resulting in inevitable frustration and drawdowns, not to mention a little emotional torture thrown in to boot! So how can we avoid this scenario and use the indicator to give us a real odds enhancer instead? The answer is simple: Combine it with the best indicator of all; namely, price.
By respecting the unbreakable laws of supply and demand, we can get a far better feel for high-probability trading opportunities, and the stochastic used in conjunction with this dynamic makes for a powerful combination. See the chart below:
As you can see, when EUR/JPY hit price support and price resistance, we still got the very same buy and sell signals from our indicator, but with far better results. In effect, we ran a filtration process in our analysis and looked for a confluence between the technical indicator and price itself. Buying in an area of demand or selling in an area of supply will always offer us the higher-probability trades, and if we use the stochastic as another level of confirmation, there will be a far more likely chance of trade success. In essence, we should look to focus on price first, and then the indicator; not the other way around.
With so many indicators available to traders via their charting packages, it is no wonder that the temptation to search for the holy grail prevails, but we all need to recognize that these tools should never be used as a crutch to lean on in times of uncertainty. Thorough planning, risk management, and objective analysis are all any trader needs for consistent results. Price will always be the very best indication of all.
By Sam Evans, instructor, OnlineTradingAcademy.com