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Reader Questions Answered

Picking the right indicator(s)

This question came in the other day from a developing trader on the subject of technical indicators.

Dear Mr. Forman,

I’m a subscriber to your trading e-newsletter. I have a market question that I’d like to ask you. I often see it written on different market websites where they say that traders should use some kind of Technical Indicators on their charts to help determine the strength on a trend. I’m strickly a retail day trader (amateur lol), and mostly on using a 50 day moving avg on my charts and drawing my SR lines. I’ve tried lagging indicators like the RSI and MACD but they only seem to confuse me. I’m wondering which Indicators you think would be the most helpful to use for the shorter time frames that day traders trade in. Thank you so much and I look forward to your answer.

Germain

The first thing I’d point out is that all indicators are lagging in some fashion. Germain mentions RSI and MACD, but anything that uses historical data – and that’s all of them – has a built in lag effect to it. The further the look-back period, the greater the lag.

Now, certain indicators are meant to filter out the noise. Moving averages are in that category. They are meant to smooth out the ups and downs to indicate overall market direction. Longer moving averages will smooth out more volatility, but will be less responsive to market change, while the opposite will be the case with shorter averages.

RSI and other oscillator type of indicators basically tell you where the market is in reference to where it’s been. The idea there is that if it moves too far in one direction it will be overbought or oversold. The problem is that doesn’t work so well in a trending market.

To my mind, the best indicator of trend is the chart. Which way is it sloping? Stepping up a time interval from the one you’re trading to a higher one to look at the bigger trend can be very helpful. Again, you’re looking at history, so you there’s always a lag effect in your analysis (a trend will change before that change can be seen on the charts), but that’s just what we have to deal with.

No matter what I say, though, indicators (or the lack thereof) are an individual choice. We all have to pick things to look at that give us the specific information we require – and preferably no more than that. Decide how you want to trade and pick the things which help you identify trading opportunities or analyze the markets based on that approach.

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Trading Tips

Looking at Stock Market Internals for Confirmation

While I’m no longer a stock market analyst (I’m focused on forex these days), I still keep my eye on what’s happening in equities. It is, after all, a big inter-linked financial world.

One of the things I watch when looking at the big stock market picture is the Advance/Decline line. Basically, that’s a measure of how many stocks have risen vs. how many have fallen on a given day. Because there can be big swings day to day based whether the market is up or down, most A/D lines do something to produce a smoothed out reading. Some are cummulative figures. Others, like the one I like to look at, is average-based.

You can see it plotted at the bottom of this chart.

SP500-103009
To be specific, the plotted A/D line above (blue line) is the 13-period exponential moving average of the difference between NYSE advancers and decliners.

I look at the A/D line as a confirming or diverging indicator. When the market is making new highs and the A/D is making new highs, you have a confirming indication. When, however, you have the market rising and the A/D line is falling you have a divergence. As you can see (highlighted by the red lines), that’s been the case recently. The market has been making higher highs and higher lows, but of late the A/D line has made a lower high and a lower low.

Divergences are warning signs. They indicate that something may not be quite right, but they don’t automatically mean the market is going to reverse. I have seen divergences persist for long periods before the market finally does change course. Also, sometimes they just don’t work out, like earlier this year. Notice how the market made a higher high in August, but the A/D line failed to do so. That divergence didn’t result in a turn down. Instead the market ended up taking off on another strong run.

Still, when you see a divergence in the A/D line, or any other type of “internals” indication, it gives you reason to be cautious. I certainly am that right now where the stock market is concerned. The recent A/D action has been very, very poor. This week’s low is below any since since the bottom in March. I would not be surprised at all to see the next rally up, if it comes, fall well short of the latest highs.

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Reader Questions Answered Trading Tips

Technical/Fundamental analysis a child’s game

A reader named nikesh posted a comment to yesterday’s Improving the Win Rate of Trend System With Oscillators entry. It brings up some things about my own approach to trading and the markets that I think could do with a bit of clarification.

i don’t want to do any effort to spill out your trading system public; but it seems that you don’t follow any MA, donchian channel sort of things (buying the strength and selling the weak), oscillitors or any thing which is so called a technical analysis. And I am almost sure that you are not trading on fundamental basis…

When you answer all these questions it seems that you have a system which is above all other things and other technical/ fundamental analysis seems a child’s game for you…

I said that i don’t want to do any effort … but still can you please give the readers some clue what exactly a successful trader like you is doing the market and making a good amount of money??????

First of all, I would refer nikesh to Can a Shared Trading Edge Still be Profitable?, which I posted the other day. That addresses my feeling on the “spill out your trading system” subject.

Don’t equate my writing to my trading
As for my not using technical analysis or fundamental analysis, nikesh has drawn an erroneous conclusion from what he’s read of my writings. When I write on this blog and otherwise discuss market analysis methods, styles of trading, etc. I intentionally try to take a neutral stance. I have things which work for me. They may or may not work for others. At the same time, things which work for others don’t particularly suit me. Unlike some commentators, I do not belittle methods I don’t particularly find useful because I realize that there is no one right way to trade or methodology to employ. I try to provide readers with the information they need to make decisions for themselves.

The reason technical and fundamental analysis may seem like “a child’s game” to me is because I’ve been at this for more than 20 years. I couldn’t even guess how much system research and testing I have put in over the years. I’ve done more analysis and trade strategizing – either for my own part or on behalf of readers of the professional products on which I’ve worked – than I care to think about. I’ve read loads of books and articles – some good, some not so much. In other words, through educating myself and application of what I’ve learned I have accumulated a lot of knowledge and experience. On top of that, teaching others creates a whole new level of awareness you can’t get in other ways. And I don’t plan on stopping any of that any time soon.

What I use in my trading
I most definitely use technical analysis in my trading. In some cases I also use fundamentals as well (primarily in my stock trading). One of the methodologies I like to employ, especially in shorter-term trading,  can be found in the Following the Quest for Value course I put together a while back. From a technical analysis perspective I could be put in the “price action” category in as much as I do not use indicators. I do keep an eye on volatility readings such as the width of the Bollinger Bands and Average True Range, but I do not use either specifically in my trading to pick trade points or stops or anything like that.

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Reader Questions Answered Trading Tips

Improving the Win Rate of Trend System With Oscillators

This question came in over the weekend from a gentleman working on improving his trend trading system.

Hi John ,

I have a question for you I’m hoping you might be able help with . I recently started researching Donchian’s Channel Breakout System to trade Forex with. Using Donchian’s 4 week rule I have my price bands set at 20 days. I ‘m sure you are probably very familiar with it. If price closed above the upper band you enter a long position and if price closed below the lower band you enter short. I like the system because of its simplicity and it appears to work on any time-frame. My question is in order to improve the winning % of trades, I have been playing with using a filter like MACD histogram but it doesnt seem to filter out many bad trades? Do you know of an oscillator that might work to help filter bad entries to incerase the winning % of trades?

Best of trades ,

John W

I am not a Donchian expert by any stretch of the imagination. As I understand its basic go with break-out premise, though, the approach is one which is focused on trend trading. That means we need to keep two things in mind.

1) Trend trading systems have low Win %
It is the nature of systems which attempt to get on and ride trends that they tend to lose more often than they win. It’s a simple function of the markets not being in real trends most of the time. Of course the idea is that when you get a good trend it more than makes up for the losses suffered during those periods when there is no trend going on. Trend trading is probably as simple as it gets in terms of trading. The problem, however, is that riding out the inevitable drawdown periods and low Win% makes the approach something many traders struggle with on a psychological level.

2) Oscillators are range trading indicators
John asked whether I know of any oscillators which could help him filter out bad trades. The problem is that oscillators are used for range trading, not trend trading. As such, they really work at cross purposes to things like Donchian. The trend trader is going with a break out at basically the same point as RSI (for example) would call the market overbought.

The only way to improve the Win % of a trend trading system is to await further confirmation of the trend being in place by using some kind of indicator or reading that is a bit more lagged than the one you normally use. Of course that then means your gains are reduced. In the final analysis you may find it doesn’t increase the expectancy of your system at all.

Don’t fixate on Win Rate!
I’ve said it many, many times. One of the biggest mistakes traders make is getting to caught up in how often they having profitable trades. It’s only one part of the equation. You also need to factor in the size of the wins relative to the losers and the frequency with which trades are made. All of that comes together in expectancy.

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Reader Questions Answered

Volume in the Forex Market

Here’s an email question that came in recently which relates to volume in the forex market.

Hello John,

I’m a Forex trader. Is there something equivalent to a buy/sell pressure indicator for the MT4 platform that you know about or can recommend.

My trade plans are less effective when the O/S or O/B conditions last for a long time. One of the indicators I use is the stochastic.

Sometimes it undulates above 80 or 30 so I’m never sure when it undulates if it going to break the high/low of the previous wave.

I’ve seen some buy/sell pressure attempted with tricks for getting the currency’s volume or with number of tics but I don’t think it a reliable way to gather this data. Any thoughts would be appreciated…

–Ermalinda

Pretty much without exception, the volume figures you see in forex are not actual traded volume. They are tick volume, which indicates how many times a given price changed. While it can sometimes be an interesting indication of how active the market was in terms of price choppiness, it gives absolutely no indication of how much actual buy and selling is being done. As such, any technical indicators based upon tick volume are of dubious value from that perspective.

The only readily available public volume figures that I currently know of are in the futures and forex ETFs. They may, at times, be useful. Just keep in mind that they only represent a tiny fraction of what is done on the spot market.

As for the effectiveness of over-bought/sold trading with Stochastics, keep in mind that they will be good during range-bound periods but will kill you in trending conditions.