Is There a Perfect Indicator?

Forex Smart Tools Newsletter ~
Volume Twenty-Five

Is There A Perfect Indicator?

In this newsletter we want to spend some time helping you answer that question. We continue to be amazed at how many experienced traders still make fundamental mistakes in evaluating indicators. They put an indicator on their chart and start looking back at historic charts and get stars in their eyes, only to be deceived by it as they take it live. Why? Usually it's because they haven't thought about their indicator correctly or asked the right questions of it.

We are not going to be focusing on any one strategy, because that's not what we do.

What do we do? At Forex Smart Tools, we position ourselves outside all the various strategies and methods of trading as independent advisers.. advisers about HOW TO THINK. The topics we focus on today aren't even about using the Trade Log, the Calculator or the Tester – the tools we offer to help you think. This will be a separate discussion about indicators offered just because we find that the people who are drawn to use our tools are traders who get ahead by using their minds to the best of their abilities – and we're all over helping you do just that. In other words, whether you're a mensa genius or not – we want to help you think like one.

Good trading to you all, Evelyn & Mindy
APs, Registered Commodity Trade Advisors    skype: forexSmartTools    twitter: @forexsmarttools

Lesson Twenty-Five - Part A: Less Is More

Reading A Chart Is Like Driving a Car

The more things you have to pay attention to, the harder it becomes and the more of your energy is drained away just through the act of paying attention.

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Each indicator on your chart should pull its weight and have significant value. Otherwise it is not just neutral – it is actually detrimental and damaging to you. There is no such thing as a neutral indicator. Everything on your chart either helps you or hurts you. Nothing is neutral. Why? Because everything that is on your chart takes visual energy, whether you consciously pay attention to it or not. Even if it is only in your subconscious awareness most of the time, it is pulling the energy that you should have available for making clear-headed decisions in your trading. If it is not truly valuable, then it's what we call an energy-suck.

That doesn't mean an absolutely naked chart is the best way to trade for everyone. Just be smart about what you pick. Afterall, even the country road pictured above has a white line down the middle. That's an indicator too, indicating which side of the road you should be on. Some indicators are great like this.

Lesson Twenty-Five - Part B: Do Research

When we started our trading careers, we had the great good fortune to attend a symposium with John Bollinger, a brilliant analist and the creator of the Bollinger Bands. His talk was not about the Bands per se, but rather the nature of indicators. He showed a typical chart in which someone had an RSI, a Stochastic, and a CCI and he got us laughing when we realized that of course you're going to say 'well, I should enter my trade here, because my indicators all line up now'. Of course they do! They all measure the same thing: price action. They are all bound oscillators based on the the high or low or close of price during a given period.

It really opened our eyes. There are a number of good websites that explain the use of most of the indicators out there. Before you get attached to using an indicator, spend some time studying its original and purpose. Know whether your indicator is a momentum oscillator, a trend follower, a volume indicator, a volatility indicator... or just what it does.

Lesson Twenty-Five - Part C: Use The Right Tool For The Job

Know The Purpose Of Your Indicator

An experienced trader recently surprised when she said "Oh I don't use Bollinger Bands. I just look at the slope of the moving average to gauge volatility".

Why were we surprised? Because that's like using a screwdriver to drive in a nail. An indicator should give you clear and unequivocal information. But using a moving average to determine slope is a subjective determination. It is soft information, not hard and precise. Compare these three charts as an example:

load images to view Chart A
load images to view Chart B
load images to view Chart C

If you were asked to describe the slope of the yellow moving average, your eyes would tell you that the moving average in chart A was up and down, sometimes flat and sometimes more steeply sloped. In chart B your eyes would say 'mostly flat with a little wave'. Chart C? "Flat as a pancake".

But guess what? These are all the same chart. That's the problem with using a moving average to try to determine slope, and from that to determine volatility in the market. that's not what it was designed for. If it were, you would get the same readings from it regardless of how zoomed in or zoomed out you were, and regardless of how much vertical squishing you applied to your chart. Because this indicator can change based on what you do, it proves that it is not the right tool for this particular job.

Does that mean a moving average is a useless indicator? Not at all. That would be like saying a screwdriver was useless. In certain applications it's the only thing that will work. Just don't use it to pound in a nail. In the same way, there are strategies and ways of using a moving average that make a lot of sense, but it is not precisely designed to read volatility.

On the other hand, you could apply a Bollinger Band squeeze indicator, or any number of other custom volatility indicators, and these would give you precise readings for what the volatility is in a manner that would not change as you zoomed in or out or compressed up and down.

Lesson Twenty-Five - Part D: Ask The Right Question

Put Your Question Backwards To Get It Right

More often than not, deciding whether to add an indicator to your charts or not means asking the OPPOSITE question. Most people ask the direct question: "Does this indicator tell me to go long now? or short?" That's the straight and obvious question. The backwards or not-obvious question, the opposite question, is in the form "Does this indicator tell me anything I don't already know?"

Here's an example from a recent webinar we listening to. The speaker had an indicator in a window below the main chart window that he referenced: "Notice how when we get our reversal arrow, we also see our magic indicator down at the bottom near the yellow line"...

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This is an example of a direct question. In other words, you could pose this question like this:
"When you see price at an upper or lower extreme, do you also see the indicator near or beyond the yellow line?"

What would the backwards or opposite question be?

"Is there ever a time that price is at an extreme and this particular indicator is NOT near the yellow line?"

Ah Ha! Now this question gets interesting. If the answer to that question is "No, the indie is always at the yellow line when price is extreme" then this indicator is telling you nothing you don't already know. It's redundant.

If the answer was "Yes, there are times price is extreme, but the yellow line has not been hit", then that yellow line indicator may be of some use to you, because you may find it points to times that are more reliable to trade than others.

Determining the usefulness of an indicator all begins by asking the right question, so try to think about it backwards. Is there ever a time two things don't line up? If they don't line up, does that tell me something useful?

Bottom line: if two different indicators always line up - throw one of them away.

Lesson Twenty-Five - Part E: Are You Getting Unique Information

Tell Me Something I Don't Know

A trader we were speaking with was saying he always looked for the signature of the green line of her indicator quickly jumping above the blue lines of that indicator and diving back into them, like the example in the chart below shows.

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Well... when does that happen? When price makes a sudden large move and retraces. This kind of move is often called an 'exhaustion candle', explosion candle or news candle.

If you see this kind of a one-to-one correlation between price and an indicator, do you really need the indicator at all?

In a case like this: NO. If the match between the look of your indicator and price itself is so much the same, then that indicator is not telling you something you don't know. You can just learn to read candles directly and throw the indicator away.

Risk Disclaimer

Before deciding to participate in the Forex market, you should carefully consider your investment objectives, level of experience and risk appetite. Most importantly, do not invest money you cannot afford to lose.  There is considerable exposure to risk in any off-exchange foreign exchange transaction, including, but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a currency or currency pair.  Moreover, the leveraged nature of Forex trading means that any market movement will have an equally proportional effect on your deposited funds. This may work against you as well as for you. The possibility exists that you could sustain a total loss of initial margin funds and be required to deposit additional funds to maintain your position. If you fail to meet any margin requirement, your position may be liquidated and you will be responsible for any resulting losses.