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Warning to Beginners: Avoid the Indicator Trap

It is easy to see why retail traders find indicators appealing because of their ease of use and clear-cut signals. In fact, many new traders think they know all about trading because they have learnt a few basic indicators that generate simplistic buy/sell signals. This kind of thinking is dangerous because it shuts them off from learning real trading skills like price action and behavioral analysis.

Warning to Beginners: Avoid the Indicator Trap

Warning to Beginners: Avoid the Indicator Trap

 

What are indicators and how are they derived?

There are only five pieces of information we can get from charts: the open, high, low, close and volume. A skilled trader can interpret this in terms of market behaviour of psychology instead of processing it as a bunch of numbers. Indicators, on the other hand, attempt to use shortcut calculations to give meaning to these numbers. As a result, they can never be faster than reading the actual raw data. Manipulating data may also mask its information quality and granularity, causing you to miss out essential essential details.

Do professionals use them?

The answer is minimally. If you go to any bank/fund or professional trading arcade, and observe the traders who trade there, you will notice that their charts are mostly blank. This is not coincidence, because such a chart setup is optimised for reading price action, with as little distractions as possible. If you don’t believe me, go check it out yourself. As said by the famous Leonardo Da Vinci, “Simplicity is the ultimate sophistication.”

The dangers of using indicators without real trading skills

Are indicators really needed for your decision-making?

Some pundits recommend a combination of time frames, indicators, wave counting, and Fibonacci retracements and extensions, but when it comes time to place the trade, they will only do it if there is a good price action setup. Also, when they see a good price action setup, they start looking for indicators that show divergences or different time frames for moving average tests or wave counts or Fibonacci setups to confirm what is in front of them.

In reality, they are price action traders who are trading exclusively off price action but don’t feel comfortable admitting it. They are complicating their trading to the point that they certainly are missing many, many trades because their over-analysis takes too much time, and they are forced to wait for the next setup. The logic just isn’t there for making the simple so complicated.

So… Should I be using indicators at all?

The best solution for the retail investor would be to first master a firm foundation of price action and behavioral analysis, and subsequently, should he choose to use indicators, should remember that as their name suggests, they are not “entry/exit signallers”, but merely “indicators”.

Therefore, it is a matter of how you use indicators, and one should always keep in mind that indicators are there to aid you in reading the price action, and not act as a substitute for it. You can think of indicators as the training wheels of a bicycle – you will want to remove them once you learn how to ride properly.

Trading always involves uncertainty, and trying to find comfort in the certainty of indicators will lead to constant indecision, second-guessing and parameters-tweaking.

The Time Element – Choosing the Correct Timeframe

Every trader knows that using multiple timeframes can provide different perspectives on the market, and provide key information on the lead-lag relationship. Small timeframes lead larger ones, and larger ones drive the smaller ones. Understanding the inter-play is crucial.

The Time Element - Choosing the Correct Timeframe

The Time Element – Choosing the Correct Timeframe

Since trends exist on different timeframes, it makes sense to analyse at least two timeframes. For example, if one’s main timeframe is the daily chart, one can consult the weekly chart to see the big picture. This allows investors to analyze a particular trend against the perspective of the next higher timeframe.

If one is using swing counts, a lower/higher high/low in the weekly and monthly charts can provide perspectives not seen in daily charts. Long-term trendlines may be clearer, and more obvious/easily visible. Certain price patterns are more visible on long-term charts (key reversals, triangles on weekly), as well as long -term support and resistance levels.

A trend change signal on the short-term (daily) may only be a retracement in the long-term (weekly) chart. On the other hand, a trend change signal in the long-term chart may be a substantial move in the short-term even though a short-term move may seem overdone. Hence, an overdone breakout on the short-term trend may actually be the start of a major breakout if the long-term chart is still on an uptrend.

Divergence signals are also more obvious when timeframe is compressed, for example a price-volume divergence is more obvious on the weekly compared to the daily. Divergences on the larger timeframes also point to larger moves, and could herald major reversals.

In conclusion, using multiple timeframes allows one to better identify trends, and more precisely pinpoint entries and exits by zooming in and zooming out from the initial point of reference. This also allows one to better manage risk in line with one’s time horizon and investment timeframe.

The Dual Timeframe Technique (NEW!)

The Only Two Things that Move Stock Prices

Despite what people may otherwise tell you or any preconceived ideas you may have, there are only two things that move stock prices. They are supply and demand – nothing more and nothing less. This is the foundation of basic economics as shown in the graph below. Since quantity remains the same, price is what fluctuates as a results of supply and demand.

If there is more demand than supply for a stock, then the price shall rise. Conversely, if there is more supply than demand for something, then the price shall fall. This is absolutely true in any market.

The next question is what affects the supply and demand for a particular security or traded instrument. Is it the profits in the financial statements? The upcoming expansion plans? The new product? Is it dividend payments? No one can be absolutely sure at any point why people may be buying and selling shares. That’s where technical analysis comes into play.

The Only Two Things that Move Stock Prices

The Only Two Things that Move Stock Prices

The next big revelation is that the bulk of supply and demand does not come from retail traders or retail investors. They come from the big boys (BB) and smart money (SM) like traders and fund managers in banks, funds and other institutions. They are the ones who move the market. Learning to interpret price action and volume is our window to tap into their psyche and profit from their actions.

Volume Spread Analysis – Spotting the Hidden Clues in Volume

Price action and volume lies at the core of technical analysis, since that is all the data a market technician works with. Almost all technical methods, such as chart patterns, candlestick patterns or even Elliot wave are studies of price action. Indicators like RSI, Stochastics or MACD are all calculated from price data as well. To understand the big picture, it pays to first understand the building blocks.

Volume Spread Analysis - Spotting the Hidden Clues in Volume

Volume Spread Analysis – Spotting the Hidden Clues in Volume

At the most basic level, price action is the movement of a security’s price. This encompasses all technical and classical pattern analysis, including swings, support and resistance, trends, etc. The most commonly known tools are candlestick and price bar patterns, which are ways of cataloging common price action patterns.

However, the crux about price action is not about memorising patterns and names. It is about understanding. That is what professional traders do. No two people will analyze every bit of price action the same way, and that is why a lot of traders find the concept of price action so elusive. That is why it takes experience to read price action.

Below is a useful picture summary of essential candlestick patterns:

Volume is the number of shares or contracts that trade hands from sellers to buyers during a period of time, and serves as a measure of activity. If a buyer of a stock purchases 100 shares from a seller, then the volume for that period increases by 100 shares based on that transaction.

Hence, volume is energy. It represents the level of commitment and participation by buyers and sellers, hence it indirectly indicates the supply/demand equation. Volume at times also serves as a leading indicator, because large movements in the market are due to the actions of market-movers (also known as the professionals or smart money), and these actions will show up in volume and price. At times,either of these two could provide the leading clues to future market movement.

The level of volume marks the significance of events – for example a breakout, a gap movement, or breaking a key support, etc. The higher the volume, the more significant these events are, because it shows more participation by smart money. In general, volume should be rising n the direction of the trend and decreasing on corrections, which would also be useful for identifying pullbacks in a trend. Watch out for unusual climatic moves in volume, for a climax usually results in a swift reversal or rebound.

The key is understanding the relationship between price and volume.

The 3 Essential Elements in your Roadmap to Success

Having studied many professional traders, I found that there are 3 crucial factors that have led to their success. All these market wizards have found success because they have understood and mastered the 3Ms of trading – Method, Money and Mindset.

Method (chart-reading): Process by which a trader enters into the market, using either technical or fundamental inputs to make their decision

Money (risk management): This includes capital allocation, risk parameters (drawdown limits), risk-to-reward calculations (entry price, profit target, stoploss)

Mindset (psychology): Market psychology the most important part of trading, and determines how well you can execute your trading plan in the markets in real time

The 3 Essential Elements in your Roadmap to Success - Wrong Allocation!

The 3 Essential Elements in your Roadmap to Success – Wrong Allocation!

To many new traders who know of these 3Ms, they tend to make the mistake of giving equal weightage to all 3 parts (refer to above), or even worse, almost 100% weightage to the “Method”. The most obvious danger is neglect to the other essential parts.

In reality, a professional trader should allocate the 3Ms as depicted below here:

“Don’t focus on making money; focus on protecting what you have.” – Paul Tudor Jones