Last Updated on 29 November, 2021 by Samuelsson
Technical trading indicators have become very popular in the financial markets. Today you can get your hands on an unlimited number of indicators through free trading platforms, which makes it hard to know which indicators to focus on. Especially considering that some people will make you think that indicators are useless!
Trading indicators are not useless if used right, but are valuable tools for most traders. However, you should be very careful with the advice that’s laid forward in books and online. In most cases, it’s outright garbage!
In this article, we’ll discuss why this is the case, and also respond to some of the most common criticisms of technical indicators.
However, as with everything in life, everything isn’t black or white, but somewhere in between. Some traders will use trading indicators in a useless way, while some will make something useless out of it.
It all depends on if you have an edge in the market, or not!
Let’s explore this in greater detail
The Purpose of Trading Indicators
In trading, your success boils down to three things, which are:
- A strategy with an edge
- Your Ability to follow the strategy
- Position sizing
First of all, you need a strategy that is has a positive expectancy. In other words, you need to ensure the strategy has an edge, and even though this might sound plain obvious, most traders don’t have a strategy with a real edge. We’ll come back to this later!
Then once you have the strategy, it’s paramount that you follow the rules you’ve set. If you’re using a fully systematic approach, which means that the strategy has clear rules that define the edge, you should never deviate from them. Many traders don’t make money, even with a winning system, since they cannot stand the inevitable losing streaks without deviating from their set rules!
Lastly, you need to ensure that you don’t risk too much of your capital on each trade, to be able to survive and recover from drawdowns.
Now, when we use trading indicators, we’re mostly concerned with defining a trading strategy that has an edge. However, they may also be used in other ways, like to decide how much money you should risk on a trade, or when you should quit trading a strategy.
When most people claim that trading indicators aren’t useful, they allude to the first point, namely that trading indicators aren’t useful to find trading strategies. So let’s start by looking at how many traders use trading indicators the wrong way!
How Many Traders Make Trading Indicators Useless
If you search the internet for guides to how trading indicators should be used, you will stumble upon a lot of different concepts and rules that apply to specific trading indicators. Most trading sites and educators will also allege that those very methods constitute profitable trading strategies.
However, this is mostly false.
Commonplace strategies, like moving average crossovers and Bollinger band breakouts simply don’t work that well. Many times they hold no edge whatsoever, which we can tell with certainty since we have backtested and rejected many of those ideas ourselves.
When some aspiring traders realize this, they instead try to combine common trading indicators, in hopes of finding a real edge. For example, they may believe that a MACD crossover works much better, just if the RSI is over a particular threshold.
Many times people go to great lengths, and fill their charts with indicators of different kinds. In reality, the only thing they achieve is a cluttered workspace that will make it virtually impossible to discover any real edge.
Sometimes you may improve the performance of some indicators by combining them, but you always want to start out with something that shows promise from the beginning. And if your strategy doesn’t have any edge at all before you combine indicators, you probably don’t want to use that strategy anyway!
Using trading indicators in the way outlined above, truly makes them useless. We couldn’t agree more!
However, there is a better way…
How to Use Trading Indicators the Right Way
Often, the most common and conventional approaches to trading don’t work that well. The more people who know about an edge, the more people will start using it which will make it disappear.
Therefore it’s essential that you bring your own ideas to the market you’re working with, to find something that works well. This could even mean that you try things that are completely opposed to the conventional approach. In fact, we often find that concepts presented work great, when applied in the opposite way as they were intended.
So how do you know what works and not?
Well, in order to test the performance of trading indicators, you need to use backtesting. This means that you use historical data to evaluate how your strategy performed historically. We aren’t going to touch on this so much in this article, but recommend that you have a look at our complete guide to building a trading strategy if you want to learn more about the process.
Trading Strategies VS Price Action – How We Like To Use Trading Indicators
A quite common criticism of trading indicators is that they simply extrapolate market data, and therefore shouldn’t be used as the main logic in a trading strategy. Instead, those who hold this view mean that a trading strategy should be based on what the market actually does, which included price patterns, or other patterns that don’t require extrapolation of data.
We certainly get their point. In the past, we’ve had more luck with finding trading strategies that are based on market action of some sort.
Still, we’ve had some great success only using trading indicators in some of our strategies.
Trading indicators are great when it comes to filtering out bad trades and improving on a trading strategy. As such, in the best of worlds, we’d like to have a trading strategy that relies on a price pattern for the main trigger, which is then improved with the help of a simple trading indicator like the ADX or RSI.
Combing price patterns with trading indicators is also a great way of reducing the risk of curve fitting. In other words, your strategies are likely to become more robust!
Trading Indicators and Concepts that Aren’t Useless!
So, while we might prefer having our strategies based on price action, there are many cases where we’ve had some great luck with indicators only. As such, we wanted to touch on one approach where indicators have worked especially well for us. We’re talking about mean reversion in stocks and equities!
As you might know, stocks generally tend to mean revert quite a lot, and by using some quite common trading indicators, we can capture this behavior in an effective manner.
Two trading strategies that do this quite well make use of the RSI and Bollinger band indicators.
Let’s have a look at both!
RSI-2 Trading Strategy
Despite being a common approach to trading, the RSI-2 strategy, where you buy on low RSI readings, works quite well.
Here are the rules for this strategy:
- Buy if the 2-period RSI goes below 5. This defines that the market has become oversold.
- Sell if the 2-period RSI goes above 50
Here is the performance if you had traded the S&P-500 according to the above rules:
Another quite useful way of using indicators, is to demand that the market closes below the lower Bollinger band.
For those who don’t know, Bollinger bands simply consist of three lines, which are centered around a moving average. The upper band is placed two standard deviations above the moving average, while the lower band is placed two standard deviations below the moving average. In other words, the market is oversold once it goes below the lower band, and this is what we may take advantage of.
The rules for this strategy are:
- Buy if the market crosses below the lower Bollinger band
- Sell if the market crosses above the middle band.
Here follows the equity curve for S&P-500.
So as you see, trading indicators aren’t useless. It’s just that you need to use them in the right way!
Our View on Common Criticisms of Trading Indicators
So, having covered what we think about trading indicators, we just wanted to respond to the two most common criticisms of trading indicators. While we don’t claim to have the definitive and perfect answer, this is an opportunity for you to get an experienced trader’s take on the issue.
1. Everything you need is already in the chart.
While this is true and you can trade just by using raw market data, the truth is that trading indicators add great value. As we covered earlier, you make the best use of trading indicators as filters or extra conditions on top of a price action based signal. For instance, there is the ADX indicator, which gives a great measure of the volatility in the market, which has a huge impact on many trading strategies. Sometimes a trading strategy might not even be tradable without an ADX filter!
In that sense, trading indicators truly add a lot of value to the trading process, and should not be discarded. And as we have shown in this article, they may even make up great entries if used in the right way!
2. Trading Indicators are lagging, and can’t predict future price moves
It’s true that most trading indicators are lagging, but it doesn’t make them useless. The state of the market preceding the trading signal is of utter importance when it comes to deciding whether a trade is worth taking or not.
As a matter of fact, some of the most effective filters include the 200-period moving average, which definitely is a lagging indicator. Still, it adds a lot of value to our trading strategies, and we will continue to use it going forward!
In our opinion, the two criticisms above are way too generalizing to be accurate. In trading, most things aren’t black or white, but somewhere in between. Besides, different traders will have differing opinions on most things, without anyone being more right than the other.
The most Useful trading Indicators
This article wouldn’t be complete without us telling you about the trading indicators we believe are the MOST useful. So here come our top three!
- RSI – Measures oversold and overbought conditions in the market, and works well with settings ranging from 2 – 10
- ADX – Measures the strength of the trend, and works in most markets.
- IBS– Measures the position of the close relative to the high-low range.
If you want to read more about any of the three indicators, you may just click the hyperlinked indicator names!
Using Trading Indicators to Improve Strategy Performance
As we told you at the beginning of the article, there is another way in which you could use trading indicators.
Now, this a quite an advanced trick that we know some traders use, so we thought we’d share it with you, even though we don’t use it ourselves.
In addition to using trading indicators to define when to enter a trade, you could bring them up to the strategy level, to assess how the strategy itself is performing.
For instance, you could apply a moving average to the equity curve of the strategy, and see if there is any point in only trading strategies that are below or above their average.
As said, we have not had that much luck with this approach, but know that some traders have developed methods where they switch on and off trading strategies based on this.
Even though there are some traders who believe that trading indicators are useless, we cannot agree.
And while most popular technical analysis concepts won’t work right out of the box, trading indicators can help you immensely if you just get a little inventive!