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Rethinking indicators

Many an expert trader will say something like ‘I rely mostly on price action, not indicators. Most indicators are useless and confusing.’ – which automatically brings up the question, “Which indicators are useful?”. But there are deeper issues.

What is ‘price action’? Investopedia says, “Quite literally, price action is everything that a security’s price does, and just like every other facet of analysis, it is purely subjective.” Expert traders may well disagree by saying that it is ‘objective’ instead of subjective. My suspicion is that expert traders are doing something rather ‘expert’ based on long experience, where they do not need to rely on indicators. As part of their expertise, they automatically (and probably unconsciously) process information on charts and come up with ideas about direction of price.

But some experts rely on a handful of indictors. Which indicators do they rely on mostly, to assist decision-making? The following is the list I’ve come up with in no order of priority or frequency:

  1. Elliot waves
  2. Relative Strength index
  3. Harmonic pattern analysis.
  4. Bollinger bands
  5. Fibonacci retracements and projections.
  6. MACD
  7. Pivot points (finding areas of support and resistance – basically).

How do experts (and I’m not one), use these indicators – and I’m talking about those who say they don’t use them? They use them cautiously to build a logical case for entry into a trade – and use their judgement about price action.

For a while – about 2 months – I went off indicators largely influenced by a bunch of experts who said indicators were pretty overvalued. And that’s fine for them – because they’ve learned from long experience how to disengage from them. But something came to my mind triggered by the chart below (click to enlarge).

Screen Shot-Williams Vix Fix-Monsanto

Just looking at the Williams Vix Fix (WVF) indicator above (disregard the science behind it for the moment), it’s clear to see that it has found quite well, important areas where price has changed direction. It’s easy in retrospect to say, ‘Well anybody could see that price was going to change there!’. But that’s about looking back now with the benefit of hindsight. When you’re watching the market though, you can’t tell by just looking at it, as it approaches one of those marked troughs, whether price is going to go up or down further. That would amount to some degree of guess-work. However, the science behind the Williams Vix Fix, is that it scans backward quite some distance, in a very organised algorithm and makes an estimate on what’s going to happen based next (that’s it in a tight nutshell). Perhaps a similar thing is happening unconsciously in the minds of those experts who would say ‘price action tells me what’ll happen next’. Bear in mind that for the above example – only a snapshot of a certain period – it might appear that the WVF is perfect. No indicator is perfect.

The WVF fails miserably on certain occasions, but it is fairly good in picking market bottoms in a ranging market (one that’s bouncing up and down). The WVF does this by combining Bollinger bands, Standard deviation analysis and applying an algorithm in the background. So it’s utilising a range of data and automatically processing it. The WVF fails mainly outside of troughs – and that’s not surprising because it’s not designed do pick up stuff outside of troughs, so common sense must prevail when using it. If an orange – aggressive filtered entry – occurs on the way up, it would make sense to disregard the ‘aggressive entry signal’. [This is not meant to be a tutorial on the WVF – which you can find done by Chris Moody who modified it for these charts].

There must be something about previous patterns and prices that tells a story about what’s to come. The story may be unclear when you’re in the middle of it. Indicators, when used sensibly of course, can be valuable in making some sense of the story. Indicators do fail. If not everybody would just use them and become millionaires in a short amount of time. See also: How indicators fail.

In conclusion, indicators are not a waste of time. Certainly for new traders, they are of value in adding objectivity to analysis. However, like any tool designed to be useful, if used the wrong way (i.e. minus common sense and care) they can cause much damage. A hammer can be useful for driving nails into wood, but get your fingers in at the wrong time and in the wrong place, you’ll hurt. Got it?

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