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How to Weed Out Overhyped Indicators
04/17/2012 9:46 am EST
Instead of chasing overhyped indicators or hot new strategies, Steve Palmquist says traders must carefully test their systems and form a solid understanding of how and when they perform most effectively.
Many traders use indicators to determine when to enter and exit trades. Most charting software includes dozens of different indicators that can be displayed on the charts. Popular indicators such as the Stochastic and MACD are frequently discussed when traders get together.
I have listened to a number of these discussions, and the interesting thing is that people typically explain why they use a particular indicator by citing a number of examples of when it has worked for them. When they do, another trader will typically say something like, “Well, it did not work for me, so I use the XYZ indicator, which is much more reliable.”
When I ask the second trader why his XYZ indicator is more reliable, the explanation usually involves a few more examples of good trades.
Examples do not prove anything. It is possible to flip a coin and have it come up heads five times in a row. Few traders would observe this and then think that when you flip a coin it always comes up heads. Yet, for some reason, people will read an article about an indicator that shows four or five examples of good trades it produced, and then they will go and risk their money trading the technique.
They typically trade this new technique until it produces several losses in a row, and then they start looking for another article that describes a “better” technique, and the process repeats itself in an endless search for a better trading system.
Successful trading should be data driven, not based on emotion, wishful thinking, or hot tips from TV hosts. To be data driven, one needs to test and analyze trading tools and find out what really works, and when each tool should be used. Traders must understand which tool to use for a specific task, and have a clear understanding of how the tool works and what can and cannot be done with it.
Traders need to extensively test several trading systems, and based on the results of that testing, they can develop a toolbox of different trading techniques that have shown effective results. They are not trading based on hunches and are instead using data-driven techniques to develop effective trading tools and understand the specific market environments in which they work.
See related: The Most Complete Backtest You Can Do
Data-driven traders first check the current market conditions, and then pull out the tools that have shown interesting test results in those market environments. The testing process helps traders understand how stocks usually behave after forming a specific pattern.
Understanding what a stock is most likely to do forms the beginning of a trading strategy. Trading without this information is taking unknown risks.
Also read: A Risk Factor Any Trader Can Eliminate