Which indicator is best?
Which suite of indicators offers a clear edge in the markets? Perhaps it is best to find out who is making money in forex, and then do what they do. Which is the magic formula? Unfortunately, the answer to this question is “It depends on who you ask.” This may very well be the correct answer. As we will see later in the book, trading is often relative and rarely, if ever, a one-size-fits-all endeavor. Some indicators are considered shams, others are misinterpreted by the masses, and still others are best used contrary to their original design intent. Indicators may be incorrect. What if the indicator is correct, but a bit slow to hint at the direction the market will take?
The indicator might provide valuable information, but might also be slow to the party, and thus not of much value. Perhaps a slight change to the indicator formula will speed it up a bit. Perhaps indicators are similar to a wristwatch, constantly improving, more features available as needed, but would it be possible to take a wristwatch, and manipulate time by running a formula through the hours, the minutes, and the seconds displayed on the wristwatch? Would the wristwatch keep better time once the formula manipulated the actual time of the day?
Using a formula to create a better time on a wristwatch may seem weird and counterproductive, but this is precisely what indicators may accomplish by changing and massaging price data. Indicator-based trading is taking a wristwatch and changing the time with a complex formula in the hopes that the wristwatch will somehow tell time better. Who wants a wristwatch with something other than the real time displayed? Do indicators (all of which are calculated using price data) allow us to understand price better?
Perhaps it is best to put aside any philosophical differences with technical indicators. Let us assume that our indicator is based upon a magical formula and this formula allows us to get a glimpse of the future. Our indicator magically transforms price data into some other number, color, or line, and suggests where price is headed in the near future. Unfortunately, even if our indicator is able to accomplish this, difficulties may endure with indicator-based trading.
Indicators are inherently slow. The market will be moving up long before an indicator suggests it is time to buy. Likewise, an indicator will suggest it is time to sell long after the market has started falling. This is one
of the main complaints with indicators: they lag behind price. FIGURE 2.1
Traditional RSI Sell Signal on AUD/USD 4-Hour Chart.[You must be registered and logged in to see this image.]
This is a fair concern. Figure 2.1
contains an AUD/USD four-hour chart with the Relative Strength Index (RSI) indicator. Traditionally, there are two RSI signals. If the RSI is above the 70 level, the market is overbought, and once the RSI falls back down below 70, a sell trade is initiated. Likewise, if the RSI falls below 30, the market is said to be oversold, and, traditionally, a buy trade is signaled once the RSI moves back above 30 (see arrow in Figure 2.2).FIGURE 2.2
Traditional RSI Buy Signal on AUD/USD 4-Hour Chart.[You must be registered and logged in to see this image.]
In these examples we see that the RSI indicator suggests a trade at about the right time. The market turned around near the RSI signal in both examples. However, the RSI did not signal a trade at the precise turning point in the market. To find these turning points, an indicator of a different type is required. One of the primary reasons why naked trading is so attractive to forex traders is because naked trading allows for early entries into trades.
Indicators may alert traders to the fact that the market has turned around after the market has turned around, but naked traders may find turning points in the market as they occur. Naked trading strategies are based on the current price of the market, and, therefore, they allow for an earlier entry. Indicator-based trade signals will lag because it takes time for the price data to be processed through the formulas that make up the indicator.
Significant moves in the forexmarket occur before a technical indicator provides a signal
Naked traders have an incredible advantage. Entering a trade early often means the entry price is closer to the stop loss price. A tighter stop loss may mean more profits, the precise reason for this is examined later in the topics. After mastering a few simple strategies, naked traders find it very difficult to move back to indicator-based strategies simply because nakedtrading strategies remove the lag time that is inherent with indicator-based trading.
Here is another example, this time with the EUR/USD daily chart (Figure 2.3)
. In this example the indicator at the bottom of the chart is the Moving Average Convergence Divergence (MACD). The construction and theory behind the MACD is not important, the MACD consists of a few moving averages. The critical signal for the MACD is when the two moving averages cross (see the dark circle in Figure 2.3).
A traditional buy signal occurs when the MACD has been traveling lower for some time and then turns around, and the faster-moving average crosses the slower-moving average.FIGURE 2.3
Traditional MACD Buy Signal on EUR/USD Daily Chart marked with a circle.[You must be registered and logged in to see this image.]
In Figure 2.3 the EUR/USD daily chart has been falling for some time. Price starts to turn around and trade higher, and consequently the MACD moving averages start to creep upward. Finally, we see the faster-moving
average on the MACD has crossed above the slower-moving average. This signals a buy trade for the MACD trader. After crossing upward on the MACD, the market does indeed move higher (see Figure 2.4).FIGURE 2.4
The EUR/USD trades higher after the traditional MACD Buy Signal on EUR/USD Daily Chart.[You must be registered and logged in to see this image.]
Although this trade looks like a nice trade, the naked trader would have entered this trade earlier than the trader using the traditional MACD trading strategy. The naked trader and the MACD trader both profit, but the naked trader is able to enter the trade sooner and use a tighter stop loss.
Tighter stops mean more money. The naked trader and the MACD trader could have both exited at the same price, but the naked trader captures more profits because the stop loss is placed closer to the entry price.
The money-management section of this book will have more information on how naked trading strategies enable traders to make more money simply because naked signals appear earlier than indicator-based trading
The MACD and the RSI are not the only indicators that lag. All indicators lag. The stochastic is a popular indicator used to time trades according to the natural rhythms of the market. One traditional stochastic trading method is similar to the RSI strategy. A sell signal is indicated when the stochastic falls below the 30 level and then crosses higher (see Figure 2.5).FIGURE 2.5
EUR/USD 1-Hour Chart—Traditional Buy Signal on the Oversold Stochastic.[You must be registered and logged in to see this image.]
The EUR/USD 1-hour chart shows the stochastic falling below 30 on the stochastic. A few hours later, the stochastic crosses upward and rises above 30, a clear buy signal. The stochastic is moving up, so price should follow. However, the market then falls a further 90 pips. For most traders this trade would be a big loser.What about the naked trader? In this instance, the naked trader gets a very clear buy signal after the stochastic buy signal (see Figure 2.6).
A “pip” is a percentage in point. One pip is equal to 1/100th of 1 percent. It has traditionally marked the smallest move a forex pair can make. Forex traders track trades in terms of pips. However, many brokers are now using “pipettes”—these are 1/1000th of 1 percent units.
EUR/USD 1-Hour Chart—Naked Buy Signal versus Stochastic Buy Signal.The traditional stochastic buy signal occurs immediately before the market falls.The naked trader has a buy signal at the market turning point.[You must be registered and logged in to see this image.]
What happens after the naked trading signal? The market jumps more than 40 pips immediately. The naked trader avoids many losing trades by waiting for a price action signal and quickly finds profits. Not all naked
trades are winners, of course, but this trade is an example of how the naked trader is able to avoid some of the very common indicator-based mistakes because the naked trader uses the price action of the market to determine entry signals.
Notice how the naked trader avoids the drawdown with this trade signal. The market immediately moves in the expected direction, upward, after the signal. Contrast this entry to the stochastic entry signal.
The characteristic indicator lag associated with the stochastic means that the stochastic trader not only enters a losing trade, but immediately after the stochastic signal the market trades in the wrong direction, and the trade enters into a protracted drawdown. In fact, it is unlikely that the stochastic trader ever had profit on this trade. Naked-trading strategies enable the trader to enter a trade based on current market price action, and often avoid the severe drawdowns associated with indicator-based trading.
Most traders believe severe drawdowns are a part of trading. This is simply not true. Severe drawdowns are characteristic of mistimed entry signals, and most traders use indicators to find entry signals, so most traders mistime entries.
by Alex Nekritin and Walter Peters