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October 02, 2007 at 6:32 am | | Comments 11

Trading With Indicators

I’m often asked why I don’t always apply stochastics or MACD or moving averages to my charts. To that question, there’s a simple and a complicated answer. The simple answer is that I prefer to focus on price and volume. My charts are cleaner and I can focus on the real buying and selling forces that are at work in a market without confusion or obscuring the most important indicator – price. The complicated answer requires a closer look at indicators.

Knowledge is Power

Indicators can be useful, but the trader must know when to apply them in order to get something useful from them. Applying the wrong indicator will only cause confusion, and trading is hard enough without adding more doubt to the picture! I have witnessed a number of traders frustrated with getting stopped out of trades when trying to buy moving average crossovers during a choppy, range-bound market. Taking trading signals from indicators must be done with the proper market conditions for which those indicators were created.

For example, a stock may be about to penetrate a key moving average, but if the stock isn’t trending then most likely you’re taking a false signal, as moving averages are rarely helpful in a non-trending environment. By definition, a moving average measures something on the move. Therefore, they are best used in a trending market. On the contrary, a stock with momentum may have an overbought reading according to oscillators, but oscillators are rarely helpful in a trending market, as they can stay overbought or oversold for long periods of time. Oscillators are subsequently best used for range-bound stocks and markets.

Selecting Your Settings

When in doubt, I will on occasion look at a trending stock and apply a moving average. However, a quick look through any trading magazine will show you that there are very few moving average periods with a wide following. For this reason, I place little weight in arbitrary numbers like 25 or 40 period moving averages which a great many number of traders supposedly follow. A stroll through any trading floor will show you the wide variety of time periods being sampled for moving averages, all of which produce different values. The 50-day and the 200-day moving averages are probably the most widely watched, but they trail price so far that most of the time a stock is some distance from either of these two moving averages, diminishing the usefulness of either for a short-term trade on most occasions. When I want to see a moving average, I prefer to apply a faster one of 10-20 days(2-4 weeks), which will often give me a better glimpse of where a stock may find recent support or resistance.

A range-bound stock will generally ignore moving averages though, which is the time to apply an oscillator such as stochastics. Oscillators help identify reversal opportunities, and are therefore better applied to stocks or markets which are stuck in trading ranges for a fade play. Anticipating reversals within trading ranges or channels is a trading style which can benefit from overbought or oversold levels as measured by oscillators, so consider these tools the next time you are contemplating an entry in such a trade.

Keep The Main Thing The Main Thing

At the end of the day, price is the most important element in any trade, and no indicator is the magic bullet that your trading has been lacking. Price is the sole indicator which is telling you right now whether you are right (profitable) or wrong (losing), and it doesn’t get any simpler than that. When you need a little extra help determining entries or exits, be sure to consider which indicator best fits the price action in question before you apply all that are available to a chart. Only then will you find value rather than confusion in the additional information that indicators can provide.

Jeff White
President, The Stock Bandit, Inc.
Swing Trading & Day Trading Service
www.TheStockBandit.com

[tags]Stock Market, Day Trading, Stock Trading, Investing, Swing Trading[/tags]