Yes, you read that right, technical indicators don’t work as most traders use them: as a trigger signal.
From moving averages crossovers to RSI or stochastics, all of them were created to represent “certain” market condition on the last n-periods, and not as a buy or sell signal.
The truth about technical indicators
As stockstocharts define technical indicators, they are nothing more than a “series of data points derived by applying a formula to the price data of a security” (or any other instrument such as currency pairs).
On other words, in order to get the indicator reading, a mathematical formula needs to be applied to the last N periods.
Right, we are talking about how the market behaved on the last N periods, not how the market will behave in the next N periods.
Based on this definition, why would I think a technical indicator is intended to show me the future direction of a currency pair? Instead, what they are meant to show (and this is the reason most of them were developed for) is to help us see certain condition of the instrument or how the market behaved over the last n-periods, again, we are taking about the PAST, it has nothing to do with future movement:
RSI(14) – RSI of 14 periods – shows us the ratio of gains over losses on the last 14 periods. If it has a reading above 50, it states that on the last 14 periods, the average gains are larger than the average losses.
If the reading is below 50, means that on the last 14 periods, the average losses are larger than the average gains.
EMA(50) – Exponential moving average of 50 periods – It tells us what’s the average value (exponential) of the instrument on the last 50 periods. If the EMA has an upward slope, it means that on average, the market has gone up, if it has a downward slope, on average the market has gone down on the last 50 periods.
I need you to have something clear
On both cases (and all indicator cases), the indicator is pointing up (or down) because price went up (or down) not the other way around. On other words, the indicator doesn’t make the market go up or down, it’s the market that makes the indicator point up (or down).
The widely used Relative Strength Index (RSI)
Let’s see a concrete example. On the following chart, I’m using an RSI of 14 periods – RSI(14):
The RSI is widely used as an overbought/oversold indicator. When the RSI moves above the 70 line, it is considered in an overbought condition (and the market should move down), and when it moves below the 30 reading, it is considered and an oversold condition (and the market should move up).
After the RSI reading went above 70 (entered into an overbought condition), the USDCHF continued its way up (it didn’t change direction), in fact, the USDCHF has moved up over 500 pips after the RSI signal.
And it is exactly the same for other technical indicators, we tend to think that the indicator will make the market move in one direction, but that’s not the way it works.
Are technical indicators that useless?
Don’t get me wrong here. Technical indicators are not useless, they help us see certain market conditions that are not clear by just looking at the market action. They help us see different possibilities, sometimes they even simplify the market movements.
And it is alright to use them, but you need to make sure you are using them as they are supposed to be used: to indicate certain condition of the market and NOT AS TRIGGER SIGNALS.
Use something different as a trigger signal: candlesticks, price action, breakouts, retracements, etc.
What do you think? How do you use technical indicators?
Feel free to comment, you don’t have to agree with me in order to leave a comment. And don’t forget to like it if you found this article useful.