Demystifying Technical Indicators – (What technical indicators really are and how to use them correctly)
Look, you know I trade based on price action and support & resistance levels, you know I don’t use technical indicators, and you know how I feel about them.
But let me tell you something…
I’m not going to ask you to stop using them (even when it is against my thought process).
If you feel comfortable with them, use them, if they give you the results you are looking for, keep using them. Just make sure you understand how to use them correctly. Alright
I’ve seen hundreds of traders using them. Some of them nail it down and use them in their favor… Unfortunately, most traders use them in a way that actually hurts them, and what is worse, most dont realize it’s the way they use technical indicators that is stoping them from reaching consistent results.
Most traders use them as if they were some kind of magical formula that will tell you what the market will do in the next minutes/hours/days.
What is your opinion?
Do you use technical indicators this way? Do you plan to use them in the future?
If you answered yes to any of questions above, then you are going to like this article.
What technical indicators really are
In order to use them correctly, first we need to understand what technical indicators really are.
This would be their technical definition:
Technical indicators are nothing more than a formula applied to the price of any instrument. Could be the closing price, open, high or low of any period.
(Below we’ll see the definition that will actually help you trade better).
For instance, this is the formula to get a Moving Average:
(H + L + C)/3 or you can use (H + L + O + C)/4
H is the high
L is the low
C is the close
and O is the open
Since it is a moving average, every time we get a new candle or period, it drops the last number and ads the new value. So every time we get a new candle, we also get a new moving average reading.
At the end with get a line that explains the market behavior in the last periods and it looks like this:
As you can see, the MA(54) explain the way the market traded in the last 54 periods, which is: going up.
You see what I’m talking about?
Again, in this article I’m going to use moving averages just for the sake of simplicity, but it is exactly the same thing as using other indicators as: MACD, RSI, Stochastics, etc. Or even the more fancy ones such as: Alligator and others.
Now, let me ask you once again, what is a technical indicator?
Here is a helpful answer:
It’s nothing more than a way to represent or explain how the market behaved in the last periods.
That’s it! Nothing more.
Note that it has nothing to do with explaining the future behavior of any instrument:
It is just a graphic representation of the way the market has been trading in the last “n” periods.
Please, read it again, because once you really understand what an indicator really is, you’ll start to benefit from them.
Agree with me?
You may ask: Ok, you are still talking about moving averages, does it apply for other technical indicators as well?
Yes, as long as they use the data of previous periods or candles, it’s exactly the same thing.
The wrong way to use technical indicators
Some traders use technical indicators as if they were a crystal ball or something similar… As if technical indicators had the truth about the market, about the way it is going to trade in the future.
Nothing can be further than the truth.
The market is what makes technical indicators behave in certain way.
- In a rangebound market, the market behavior makes the moving average flat (no the other way around, the flat moving average does not make the market go rangebound).
- In a bullish market, the market makes the moving average point up (not the other way around).
- And finally, in a bearish market, the market makes the moving average point down (not the other way around).
Let’s use a moving average of 54 periods – MA(54), which happen to be the same chart we used in the previous example:
Wrong way to think about this chart:
Since the MA(54) is pointing up, the market is likely to continue its way up.
The right way to think about this chart:
Since the MA(54) is pointing up, I know in the last 54 periods the market has been going up.
Remember, the only thing technical indicators tell us is how the market traded in the last periods. In this case, how the market has been trading in the last 21 periods! That’s it!
We need to have something clear though:
True fact: the way the market traded in the last 54 periods has nothing to do with the way the market will trade in the future.
Read it again please.
You cant take a trading decision using just that information, it would be like a flip of a coin
Do you agree with me?
Ok so, this is the wrong way to use technical indicators:
You open up your charts, and without any prior analysis you start looking for signals such as this:
- Moving average cross overs
- RSI or momentum signals
- MACD divergence
- Stochastic overbought/oversold conditions
And most of the more fancy technical indicators.
Takeaway: technical indicators tell us how the market traded in the last periods. That’s the reason most of them were developed for.
The right way to use technical indicators
Ok, now lets talk about the way technical indicators should be used.
Basically there are two ways in which technical indicators can be used to get good results.
1 – An easier way to represent market movements.
Sometimes it’s difficult to have a clear idea of what the market is doing just by watching price action.
Under this circumstances using technical indicators make sense.
See this chart for instance:
Focus on the green rectangle. It’s kind of difficult to see what the market is likely to do right?
Now take a look at the same chart with a moving average:
Now what do you think about this chart with the a MA(54)?
Much clearer isnt it? Now its clear that the market is likely to continue it’s way up.
And the same can be applied using MACD , RSI, Stochastics, or any other technical indicator that you cold think of.
2 – As a part of a system (i.e. entry signal)
This is what I’d call the perfect way to use technical indicators.
You have a complete system:
a – First you do your analysis and determine which currency pairs to trade and what direction to trade them (long or short or no trade at all)
b – Once you know which currency pairs to trade (and the direction), it’s time to use a technical indicator as an entry signal, which could be any of the following:
- Moving averages crossover
- MACD, CCI or RSI divergence
- Stochastic overbought/oversold conditions
- Momentum reading-mark crossing
Or any other indicator you like such as the more fancier ones (think alligator).
So as a part of a system, I think it’s alright to use technical indicators as an entry signal, once you understand what the market is likely to do.
You see the difference between the wrong way to use them and the right way to use them?
Wrong way: with no previous analysis, use technical indicators as an entry
Right way: As a part of a system, once you understand what the market is likely to do, use technical indicators as an entry signal.
What do you think?
I’m interested about what you think of the way I suggest to use technical indicators?
Have you used them before? With what results?
Do you plan to use them in the future? Dont hesitate to comment the way you plan to use them to get my feedback.
Let me know in the comment section.