How to Effectively Work with Trading Price Indicators - dummies

How to Effectively Work with Trading Price Indicators

In analyzing a chart of trading prices, indicators measure changes in market sentiment — bullish, bearish, and blah. Indicators are only patterns on a chart or arithmetic calculations whose value depends entirely on how you use them. You use indicators for many trading-related decisions, including identifying a trend, knowing when to stay out of a security that isn’t trending, and knowing where to place a stop-loss, to name just a few:

  • Understand your indicator. Use indicators that make sense to you in terms of crowd behavior. Think of technical analysis as a giant department store full of indicators. One department or another has an indicator that can work for you.

  • Trade what you see. Patterns are indicators, too. Prices never move in a straight line — at least, not for long — and patterns can help you identify the next price move. Some patterns are easy to identify and exploit, while others may elude you. If you can’t see it, don’t trade it.

  • Use support and resistance. You can pinpoint support and resistance by using any number of techniques. Momentum and relative strength indicators can help estimate support and resistance, too.

  • Follow the breakout principle. A breakout tells you that the crowd is feeling a burst of energy. Whether you’re entering a new trade or exiting an existing one, trading in the direction of the breakout usually pays.

  • Watch for convergence and divergence. When your indicator diverges from the price, look out. Something’s happening. You may or may not be able to find out why, but divergence often spells trouble. Convergence is usually, but not always, comforting.

    If your security is trending upward and the momentum indicator is pointing downward, you have a discrepancy. The uptrend is at risk of pausing, retracing, or even reversing. If you’re risk averse, exit. Look for divergence between price and volume, too. The most useful divergence is a paradoxical one, where the price is falling but by less than abnormally high volume would suggest. This divergence may mark the end of a major downtrend and is more reliable than the percentage retracement or round numbers touted by market “experts.”

  • Backtest your indicators. Standard parameters are useful over large amounts of data and large numbers of securities — that’s why their inventors chose them. But if you’re going to backtest indicators to refine the parameters, do it right. Use a large amount of price history when testing an indicator — and don’t make the indicator fit history so perfectly that the minute you add fresh data, the indicator becomes worthless (a waste of time called curve-fitting).

  • Acknowledge that your indicator will fail. It’s a fact of life — your indicator will fail and you’ll take losses in technical trading. Don’t take it personally. Indicators are only arithmetic, not magic. Console yourself with knowing that using indicators reduces losses over winging it, but indicators never eliminate all losses.

  • Accept that no secret indicators exist. The secret of successful trading doesn’t lie in indicators. Shut your ears to the guy trying to sell you an indicator that “never fails!” Of course it fails. If it never fails, why would he sell it to you? And why should you have to pay for an indicator in the first place? You don’t. Every indicator ever invented is easily available in books, magazines, and on the Internet.