When it comes to indicators, there is one significant difference I have noticed between novice traders and experienced ones.
The novice trader will put an indicator on the chart, scan it for a while, and would get an orgasmic high - Oh that cross over, oh that divergence, that's all I need to catch. And, those of us who have been through it know, that looking at charts in hindsight is different from trading them on the go.
So what is the way out? Abandon them all? Trade naked charts? Which one's to use and which one's to leave?
In this short series I will share with you some perspectives on Indicators and and their use.
Let's start with the Question - What is an Indicator?
An Indicator is nothing but an analysis of historical market data, I use the word historical because its "past", we cannot calculate or analyze an event till its done. If you are looking at a Moving Average crossover it will calculate only after an event ie Open or Close of a price point. So essentially its history, its an analysis of the past data.
Does it have any predictive value? Hold on to your horses, we will come to that later.
Question 1 - How do we go about choosing indicators that would aid our trading process?
Not many know, but I am a PhD program dropout not once but twice, and one good thing that happened because of that is, I ended up attending the basic research coursework twice, and one of the things that they drill into you in that course is about the idea of Inductive vs Deductive reasoning.
So basically this is how we would apply this idea to Indicator selection -
Deductive Approach - Hypothesis first! -> So we would form an hypothesis, say you have been observing the markets for a long time and you see some pattern occurring several times - Lets say you have seen that once a crossover of 10 period EMA and 60 period EMA happens it stays that way for some time. So what you have is a hypothesis that you have arrived at based on observation - Now you need to use data to test it to see its validity - If it holds well, then you use that indicator to trade.
Inductive Approach - Data first! -> So lets say you have historical data, and you see a pattern in the data based on tests that you run, you see that the average trend duration is 60 minutes in the market that you trade, now if you want to trade that pattern (in that data), you could use an indicator to help you catch those trends - A a crossover of 10 period EMA and 60 period EMA could be one of the ways of doing it.
So these are two broad approaches to getting to indicators, but as you can see in both approaches a "back-test" is a must.
In Part 2 we will explore the question - Do Indicators have any predictive value?