Indicators

You can look at the sun or the moon, but can you make out any details of its composition? Now assume you are studying an satellite or exo-planet few million light years away, what chance do we have studying it in the way we would have studied the sun or moon?

Now, think of it as studying a far off planet with new technologies, you can change your lenses and camera to study different aspects of the planet. You can change to infrared to understand its thermal composition or to spectral analysis to understand its atmospheric analysis. You can study its different aspects by using different and specific tools.

Similarly in stock markets, price is the only data that comes out of the market. Price chart is the only chart that you have to make sense off, however it is almost impossible to make sense of almost all the time. At such times when we cannot make anything out of it, we have to use different lenses to understand its different aspects that form the chart. To enable such analysis we use indicators which are derivative analysis of the OHLC and volumes data of the price. Several other data points can be locked in to study them simultaneously.

Indicators are tremendously useful because indicators are built to answer one or two specific questions. And when a trader has such a question on the price, all he has to do is to check the indicator readings and what it portends.

Though there are hardly few major data points to go around, there are probably millions of derivative indicators. There are complicated indicators, simple ones, highly derived ones, simplistic ones... basically; you will find indicators of all hues and sizes. There are few versatile and proven indicators which helps trader.

[Tip: Less one uses the number of indicators the better it is. For instance, if you are using maximum of five indicators, that’s too much.]

There are few indicators that are most commonly acknowledged by the trading community. Every indicator will have its proponents and opponents. There are people who use an indicator and who don't use it. The point for the trader simply is to know if that particular indicators works for him or her, in step with their style of trading and does it fulfill its utility in answering their questions and keeping them informed of the price's health. If the indicator can prove such a utility to anybody, then irrespective of the general review that indicator may be used.

When selecting and working with an indicator, few points that have to be taken care of are:

Specificity

Indicators are created with some specific purpose. Some indicators are meant to signal the overbought-oversold moves, some are meant to indicate break in a trend or a breakout of a trend, some are meant to indicate the increase or decrease in momentum etc. There are n-number of reasons why an indicator is created and how it can be modified.

When using an indicator a trader has to understand that he / she is using the indicator in the way it is meant. If you use the indicator to give the results it is not supposed to give, then the trader is actually being misinformed.

Common Knowledge

One of the main reasons common indicators should be chosen to trade and not highly modified unique in the world, is that indicators also tells you what your opponents and market players are thinking about in the market. In other words, it helps you understand and break into the circle of common knowledge. For instance, if you see an indicator being watched by all players closely, then it may become essential to front-run the indicator as not everybody watching would be successful in trade. However, if you were not watching that indicator, you would miss out crucial information of what your opponents were thinking.

  

It always pays to follow the commonly established indicator for two main reasons: one, since these are well established indicators you are getting a proven indicator and second, it helps you understand what most of the world / opponents are watching and thinking.

Limitations

The biggest mistake most of the people / traders ever make in technical analysis, and something that is most easily solvable, is not understanding the limitations of the indicators they are using.

Due to the basic construct of the indicator, indicators cannot give you all the information (they are specific) and they cannot be useful all the time (because of their structure). Simply said, your indicator will start lying to you at times, it’s not the fault of the indicator but because the indicator is not able to process the data which are beyond the work of its parameters. IF you can understand when and how the indicators will fail and are failing and know how to stay away from them at those particular chart phases, then you have pretty much nailed the most important clue you will need to trade.

This is so important, yet unfortunately so badly understood, that it bears a repetition. Let’s assume you have a car with tires fitted on (obviously, duh!). Now, most probably those tires were bought for and are suitable for city commutes and it may have served you very well with safety and no accidents. However, if the scenario changes to say a high speed highway drive or a rough gravel drive or rain and sleet or a sandy path; the trusted tires are of no use and at some point will fail to provide the same protection it gave us in the city traffic. As long as we understand the limitations of the devices that we are using, then we can safely use them at appropriate times.

Knowing the limitations of the indicators you are using is of critical importance.

Serendipitous Gifts

  

The indicators though made for some specific purposes, are all driving the data from the price data. Therefore the patterns reflected in the price will be reflected in the indicator also - irrespective of the purpose it was designed. These are some serendipitous use of these indicators, where the indicators give inkling to the future moves far-ahead of the moves than would be given by the designed indicator, even though the (serendipitous) indicators was not designed for such a purpose.

Without going into details, the point to note is that there are patterns in indicators as much as in price charts. And few of these indicator-patterns are very reliable in forecasting what would be happening much ahead of the price actions.

Indicators are essentials to trade in the sense that it eases the way to trade. However, excessive use of indicators will cause bad trades. Understanding the limitations of indicators is also of crucial importance.