Trading with Indicators

The Function of Indicators in Trading

There are a lot of different indicators that have been formulated and developed over the years to assist traders in making trading decisions. All of them look to provide information based upon analyzing past performance to look to assess probabilities of future performance.

Critics of indicators, which include some traders as well, claim that indicators are always lagging, taking into account previous activity when they want to focus on the present. A good example of this would be using moving averages, which account for the present period as well as a certain amount of past periods, depending on the setting, and average out the prices over this longer period in some way.

This indicator does indeed lag, as if a move happens, it will take time to adjust to the movement. If the price declines for instance, the moving average will not decline in step and may even increase for a while as the price moves in the other direction.

If we look back at movements that have already happened, we might wish to have the indicator deliver signals in a more timely way, before this or that much movement against our position occurred, but the purpose of indicators is to look to smooth out data in such a way that its signals can be more reliable than just looking at a price line chart.

Traders can trade purely from the chart, and some do that successfully, although when you do this you still need to avoid your system producing too many signals, which can result in not only overtrading but getting whipsawed, where you may be both getting in and getting out at the wrong times.

Technical indicators therefore function to smooth out data. Smoothing out data is something we need regardless of the trading strategy we use, even if we are just trading based upon price on a chart, using the current bar or even from a quote screen.

The Need for Providing Room for our Trades

The extreme version of trading price would be to enter on an uptick, where the price of the last trade was higher than the price of the one before, and exit on any downtick, where the price declined from the previous trade.

Given the nature of markets, where prices typically move up and down all the time, this would produce a ridiculous amount of trades and be very difficult to manage from a practical standpoint. This could be accomplished by setting up an automated trading system, but prices change so quickly that even the very fast execution times that we enjoy these days would not even be able to keep up to this order flow, not to mention be able to manage the extremely high trading costs involved.

What we look to do instead is to give our trades various amounts of room to breathe, where we are prepared to go through a certain movement against us, and we’re then looking to decide which movements are significant and should be acted upon and which ones aren’t.

We could, for instance, trade price with a trailing stop, where if the price ever drops by a certain amount, we will exit. This can be set up through many trading platforms such that you can just place a trade and forget about it, and the software will produce a market order to close the position should our trailing stop be hit.

While profitable trading systems can be designed this way, trading is about seeking out not only a profitable strategy but an optimal one, or at least a more optimal one as we strive to improve our skills and trading rules.

Indicators can assist us in doing this, for instance using moving averages to smooth out the data and separate trends that are meaningful for our time frames from those which are not. The goal here is to provide us actionable signals which will be to our benefit if followed, keeping us in trades more when we should stay in and getting us out more when we should get out.

Ultimately, this will seek to provide our trades with not too little room, not too much room, but an appropriate amount. We are seeking out pivot points for the movement that we are looking to take advantage of, and within every trend is many smaller trends, and therefore the plan is to weed out the smaller trends and focus on the trend we wish to focus on.

To the extent that we get this right, this will provide us with a good way to decide when to enter and exit trades, according to the signals provided by the indicators we choose when trading with indicators.

Choosing Among Indicators

Less experienced traders may want to do too much with indicators, which can lead to overly complicating one’s trading system. The key is actually to not use too many and to also choose the right indicators, and just because an indicator is available and is used by some others does not mean that you should use it.

If you use enough indicators, you can get into a situation which will lead to an extremely conservative system. This will produce few if any entry signals because some indicators will suggest an entry and others may not, and the goal isn’t to keep you from entering profitable trades.

While waiting for the perfect setup, where all your indicators align, many good trades can and will pass you by. Once in a trade, if your criteria for exit is set so that many indicators need to indicate you stay in the trade, you will also tend to exit too quickly and leave too much money on the table.

We therefore need to be selective in the indicators we choose and also make sure to not complicate things too much, and simplicity is certainly a virtue in trading. Trading is always about assessing probabilities well enough to obtain an advantage, and therefore, as a general rule, a profitable edge is always enough, because if we don’t take the trade or exit it too soon then this profit is not achieved when we’re flat.

There may be some marginally profitable situations that should be passed up on if better opportunities exist with other trades, for instance exiting a trade which has gone flat in favor of entering another with more promise. Overall though, we need to be primarily focused on the trades that we are in first learn how to manage it properly before we can progress to concepts like relative value.

Keeping Your Indicators Simple Enough

Top traders generally look to trade with just the right amount of trading rules, which tends to be considerably less than struggling or newer traders imagine. Some just use simple indicators like moving averages and rely on nothing else.

These are traders with vastly more experience and considerably more skill than newer traders possess, so if they are looking to keep it simple, the less successful and experienced trader certainly should.

This does not mean just going with a simple moving average and looking to this to generate all one’s signals, but that actually isn’t a bad place to start out learning about managing indicators, and there’s a lot more to this than just reading about a certain indicator, adding it to a chart, and then sitting back and watching for the signals.

There is a lot of latitude in even just one simple indicator like this, as you are going to need to decide what periods to apply it to, what the length of the indicator will be, whether you are going to trade it over or under the signal or whether you are going to use the direction of it, and so on.

Putting Indicators to Work

You will also need to build in other criteria to this, as you want to look to separate the good signals from the not so good one, especially potential whipsaws that result things go too flat. Just like trading on every tick, you want to avoid acting on too many signals, and moving averages as well as other trend following signals have the potential to produce too many signals if not used properly.

You will also need to seek to align your indicator or indicators to the behavior of the asset that you are looking to trade, and while many indicators can be used with just about everything, there are often adjustments that can be made to improve performance, to produce better signals.

Not all indicators are created equally, and some just have too much lag to them or may produce far too many signals, or both. Since the goal here is smoothing of price, ideally your chosen indicators should provide enough smoothing but not too much of it.

Jagged looking indicators or those that require a more complex set of rules aren’t ones that work that well, nor should they be a part of a newer trader’s tool kit, because the goal is to keep things simple. That’s always the goal but it’s an especially important one for newer traders.

Often, it is not so much the choice of indicator but the choice of settings, and like moving averages where you can set the length of the moving average, there are settings that can be adjusted with most indicators, to allow a better fit to one’s trading plan as well as producing better signals.

This might sound more complicated than it is, and it certainly can be very complicated, but that’s not the goal. On the other hand, it is not just a matter of bringing up an indicator with stock settings on a chart and just watching it go up and down and trade that, as there is some skill involved and we need to be open to looking to play around with our indicators as we see fit.

Getting better at using indicators and getting better at trading go hand in hand, and while becoming a good trader involves more than just being able to generate good trading signals, this is a fundamental aspect of trading, regardless of whether one uses technical indicators or some other means to measure momentum and act upon it.

Skills in using indicators are ones that take some real time to develop, but provided one applies oneself well enough and understands what indicators seek to do, to produce more opportunities to make money than to lose it, one is on the right track.