Do Indicators Really Work In Trading?
A popular way to trade these days is via Price Action, this means trading on clean price charts. Giving the impression that indicators are ineffective or useless in trading, this is NOT true. As a trader, knowing these popular indicators will vastly improve your understanding of the markets. While it is not necessary to use them in your trading, simply understanding how these 5 popular technical indicators work, will give you better perspective of the markets.
These indicators each try to measure different aspects of price, as a new trader who does not know how to approach the markets, this will give you an idea of how to view the markets.
In general, these indicators are grouped into 2 types. One type measures direction of trend, the other type measures momentum.
These are derived by continuously averaging prices over a defined past period. Connecting every reading produces a line which moves with price.
It is useful in keeping an objective view of trend even when prices are “messy”. Usually we use 2 moving averages of different periods. When these 2 lines are moving parallel to each other, there is usually an established trend in price. And trend followers will trade in the direction of this trend.
If the moving averages are crossing frequently, usually it signifies no good trend is established and we shouldn’t attempt to do much trend trading on that market. Moving Averages can also be used as dynamic support and resistance, especially in established trends. The slope of a Moving Average can also be used as an indication of the strength of the trend, the steeper the Moving Average, the stronger the trend.
Moving Average Convergence And Divergence Indicator (Known Simply As The MACD)
This is a 2nd level derivative of price, because it is derived from 2 moving averages and not directly from price. This indicator comprises of 3 parts, the MACD line, the signal line and the MACD histogram. The MACD line is derived from 2 moving averages. The signal line is the average of the MACD line over a number of periods. The histogram is the difference between these 2 lines.
This indicator measures the strength and direction of trends. Very similar to Moving Averages, but it hopes to reduce false signals and yet respond quickly to changes in trend.
The crossovers between the MACD Line and the signal line can be used for trade entry, although as with most trend indicators, it will be a late signal.
Histogram is an indication of trend strength. It is the difference between the MACD and the signal line. Thus it will react faster than a crossover in identifying weakening trend, but will generate more false signals.
This is known as an oscillator. It measures overbought and oversold conditions in the market. This is done by comparing the current price with prices over a period of time in the past, then expressing this as a percentage of that range. This indicator has 2 lines, the stochastic line and the signal line. The underlying belief behind this indicator is that price is mean-reverting and will usually turn after moving to extremes. It measures this level of extremity in direct relation to the range covered over the previous period of time. Hence, the reading only goes from 0% to 100%.
It is popularly used to identify periods of extremes in market conditions, namely overbought and oversold environments. Traders should note that prices can stay overbought or oversold for extended periods of time, especially during trending periods.
Another way the Stochastic oscillator is used, is to identify divergences between price and the oscillator, to indicate a potential reversal of trend.
Also known as the Momentum indicator, measures momentum of price. It expresses this as a percentage change of current price and price a number of periods ago.
Similar to the Stochastic oscillator, it is used in identification of overbought/oversold environments. Divergences can also be observed and crossovers on the zero line are also helpful to determine if the market will reverse in the opposite direction.
The difference between ROC and stochastic is that ROC is not confined to a 0-100% range. hence, it is a more objective reflection of momentum. It is also represented by a single line but the stochastic is represented by 2 lines.
The underlying concept for this indicator is similar to the stochastic oscillator, in that it believes in the mean-reverting nature of price. That price will reverse after moving to a point of extremity, Bollinger bands however, derive these levels of extremity by doing a standard deviation calculation over the immediate past period of price points. It is expressed with bands which move with price.
It is used to fade price at extremes, but also to identify trend re-entries.
In general, oscillators will perform better than trend indicators in range bound markets, while trend indicators like Moving Averages and MACD, will perform better in trendy environments.
However, a combination of both types can result in a robust trading strategy.
I hope this has helped you gain more perspective about the markets.