By Andrei Knight
We’ve all spent time pouring over various indicators, trading systems, and other gizmos, trying them in various combinations, and often to our eventual frustration and disappointment.
They all seem to work for a time, and then suddenly stop. What made them quit working? Are they broken? No… chances are, the market conditions have changed – and they often do – but
you’re still using the same indicators the same exact way. In other words, they no longer fit the situation.
The Two Kinds of Indicators
No one really mentions this in discussions of indicators, but most of them actually fall into one of two groups. You have your trend-followers, which measure increasing or decreasing momentum, and you have oscillators, which cycle through bullish and bearish cycles or waves. On the trend-following side, you have indicators such as MACD (Moving Average Convergence and Divergence), OsMA (an Oscillator of Moving Averages), and ADX (Average Directional Index).
Oscillating indicators include things like the Stochastics, RSI (Relative Strength Index), and CCI (Commodity Channel Index). Stochastics oscillate between 20 and 80, the RSI between 30 and
70, and the CCI has 0 in the middle and oscillates between -300 and +300 – but the idea behind all of them is more or less the same.
Which is the best? Here’s the cool part… it doesn’t really matter! Use whichever you like. The important thing is to have one indicator from each group, and – here’s crucial bit – to know
when to use which.
How do we do that? Glad you asked!
Evaluating Market Conditions
In order to pick the right indicator for the job, we first have to understand what the markets are up to. At any given moment, markets are doing one of three things: they can be trending, ranging, or reversing – and a reversal is nothing more than a new trend emerging in the opposite direction out of a range.
Sure you can probably look at a chart and figure out which of these it is (and if you’re not sure, try a higher timeframe, or simply get out of your chair and look at the chart from the back of your room while squinting your eyes – it helps, really). But, in order to be disciplined traders, and follow a repeatable system, we have to take as much subjective judgment out of the process as possible. What we need is a “market conditions indicator”. And thankfully we have one, in the form of the ADX.
Wait! Didn’t you just say that the ADX is a trend-follower? Well, yes, technically it is. If you color the +DI line green and the –DI red, and put the indicator right under a MACD with the standard settings (12, 26, 9), you will notice they are telling you almost the same data. When the green line is on top, your MACD histogram will be printing bullish bars, and when the red is on top, you will see bearish bars. When the +DI and –DI lines get further apart you should see taller bars, and when they get closer together you will see shorter ones.
For our purposes, though, we’re going to color the +DI and –DI lines black (or whatever the color of the background of your charts is), and simply focus on the average line. Set the number of periods being averaged to 14, and add a horizontal line at the 30 level. When the ADX is over 30, you are in a trend, and should switch to using your trend-following indicator (I prefer MACD or OsMA histograms here, as they are easier to see than the ADX’s DL lines, especially when you have multiple charts open). When the ADX drops below 30, you have fallen into a range, and your oscillating indicator will most likely give the clearer, and earlier signal. It’s that simple – pick the right indicator for each job, know when to switch them, and you will find them being much more accurate in their readings for you.
Hold On… Aren’t All Indicators “Lagging”?
In principle, yes. Indicators perform their calculations on changes in price. Therefore, price has to move first, then the indicator has something to calculate, and afterwards it displays the result. But this doesn’t render them useless. Far from it!
For starters, indicators should not be used to generate entry signals. They are used to confirm entry signals, once you think you’ve spotted a potential entry from the price action itself. Analysis begins with the chart itself, not with the things underneath it. In other words, don’t try to lead with a lagging indicator. Price is always king.
Second, it is precisely their “lagging” nature (and we’re really talking a matter of seconds here, folks – computers are pretty fast these days) which keeps us from over-trading, which study after study has proven is the number one cause of losses.
When we are in a trade, and price moves against us, we must decide if this is just a short-term retracement, or the beginnings of a longer-term reversal, in order to determine whether to stay in or get out. If price reverses but the indicator remains pointing in the original direction, then the counter-move is likely to be short-lived. If, on the other hand, both price and indicator turn together, you’re likely facing a reversal.
Again, simple. I like simple – because it works.
Using Old Indicators in New Ways
Depending on how it is used, a “lagging” indicator can sometimes even give you leading signals. There’s no need to shuffle your system around and try or buy every new widget that comes along. The key to solid trading is using a few basic tools, but getting to know them and their responses really well. This is where practice and “screen time” come in.
Trending-following indicators can sometimes form a divergence. This is when price makes a higher high, a new peak, but the indicator’s peak fails to form a higher high, or when price makes a lower low, but the indicators fails to follow. This is usually a sign that your trend is at an end.
Sometimes, your trend-following indicator will go towards 0 in the middle, but then reverse and come back out. This is what is known as a “zero-line rejection” (or simply a ZLR for short). This is a sure sign that the current trend, even if ranging or retracing a bit, is about to resume and go even further. Often much further.
And, as you’ve probably guessed, a ZLR cancels a prior divergence signal, and a divergence cancels any prior ZLR. Each signal basically is valid until we get the next, new signal. Since both of these are significant signals, beyond just momentum increasing or decreasing, I tend to take notice of them even when the ADX is below 30.
Besides oscillating up and down to indicate bullish and bearish waves, oscillators also have their unique signals – when they form Ms at the top or Ws at the bottom, they are often predicting a longer-term shift in overall direction.
Finally, just like on the price chart, I like to draw trendlines, triangles, and ranges (on both of my indicators) whenever I see them. Just as with price, a break of a trendline can foreshadow a significant change in the overall market conditions, often heralding the emergence of a new trend.
As you can see, very often it is not the indicator that’s the problem, but how and when the trader chooses to put them to use. Hopefully this article has given you a few new and useful ideas on how to use your favorite ones! The best part is everything presented here can very easily be combined with whatever trading system you may be using already to help confirm the accuracy of its signals.
Andrei Knight is a fund manager, trading coach, and a highly sought-after speaker who has appeared at events including the World MoneyShow, The World Energy Forum, Traders Expo, IX Investor, and the International Traders Conference. He is the author of “Trading Forex for a Living” from Harriman House, and is featured in the forth-coming documentary “Fibonacci: Unlocking the Market Code”. He has appeared on CNN, CNBC, and contributes regularly to TradersLog, FXStreet, DailyFX, and the International Business Times, where he also sits on the advisory board.
Mr. Knight provides strategic market analysis for leading Swiss broker Dukascopy, and has previously worked for giants such as UBS (one of Switzerland’s largest banks) and Deutsche Bank (trading the world’s largest volume of forex transactions), as well as a prominent Los Angeles investment firm which manages funds for celebrities and other high net worth clients (named a top asset manager by Bloomberg). With his background as both a martial artist and a tournament chess player, he brings a unique perspective to the financial markets.