Getting Started With Indicator Trading

The debate about whether indicators or pure price action is more effective is probably as old as trading itself.

The one and only answer, though, should be: BOTH!

As you will see, there is virtually no difference between indicator and price action trading and both approaches are based on the same data. In the end, you will get the same results regardless of which approach you chose. It only comes down to what a trader’s preferences are. This holds true for anything trading related.

Indicators 101

Indicators are tools that take price and/or volume information, apply a formula to it and then transform it into visual information such as graphs or oscillators. By analyzing and crunching price data, indicators provide information about the strength of a trend, momentum, potential turning points and possible reversals.

Indicators do not add or subtract anything from the price information. Thus, a well-trained trader will always get the same information from his/her indicator as from pure price action data.

Problems arise when traders are ignorant and do not spend time understanding indicators. A trader who has never looked at the formula of an indicator will, of course, draw the wrong conclusions. If you want to see what it really takes to understand how an indicator works, I recommend reading our STOCHASTIC guide. This guide demonstrates why indicators are usually misunderstood and used in the wrong context.

Further reading: Indicators work. But you don’t know how to use them

An indicator uses the candlestick high, the lows, range size, the open and the close – among other data points. Therefore, an indicator can even show more accurate and conclusive data than just pure price action because traders generally do not know how to relate price data into meaningful relationships. It is, thus, critical for a trader to stay open-minded or he might miss valuable information.

Indicator myths

While we are at it, let’s discuss the 3 most common indicator myths and by the end, you will be able to see why the majority of traders is usually wrong about indicator trading.

1. Indicators lag
   Let us start with the most ignorant myth first to get it out of the way. Indicator “signals” have no lag in them and a look at how any indicator works will immediately show this. However, an indicator will give you a signal as soon as the candlestick has closed. This is the exact SAME moment when the candlestick gives you the signal too.  A candlestick pattern can only be confirmed once the candle has closed too.Only amateurs who blindly jump in and out of the market during the candle duration believe that they experience lag. However, their price action trading is also not profitable because they never wait for confirmed information and react impulsively.Indicators use a “period” setting which means that they analyze the price action over a past time period. This is not the same as lag, but it’s a way of coming up with exact and robust information about what has happened and what IS happening right now. Indicators provide meaningful data by looking at a broader market context which usually provides superior results.
2. Indicators are messy – price action is clean
   This comes very close to being the most ignorant statement. Any chart can be made messy and/or clean. It is not uncommon for price action traders to get lost drawing too many support/resistance lines, trendlines, etc. until they end up with paralysis by analysis because they do not know what to focus on. Or, price action traders who trades purely naked charts easily feel lost when they do not have reference points.The same is true for indicators. You need to find the sweet spot between information overload and not enough. But saying that only price action is a clean way of trading is probably as wrong as it gets.
3. Price is king
   Really? And what does this even mean? Price action essentially is also just a way of visualizing trading data. Is price action then not just also a derivate of something else? Indicators do not add or subtract anything from price action AND indicators are usually better than looking at price action alone. Each indicator has been built for a very specific purpose and, thus, is the specialist in a certain way of trading. Whereas price action is more a raw form that still has to be put into the right context.

Trend vs. range indicators

Indicators fall into two major groups: the first one can be used within established trends, the second one provides information during range-bound markets. The range indicators are called oscillators which move back and forth between fixed values. The other group which contains trending and other indicators are not bound by fixed boundaries.

Although there are indicators that don’t fall into these two categories, in the following we focus on the most commonly used indicators and provide an overview, the features and what to be aware of when it comes to using indicators effectively.

#1 Trend indicators

Indicators used in trending markets come, in contrast to range-bound indicators, in different forms. Whereas some are plotted directly on the charts, such as moving averages or Bollinger Bands, others visual price information in the regular ‘indicator’ area below the price chart.

Trend indicators are mainly used to identify the beginning of a trend, the strength of a trend or to spot trend reversals by analyzing declining momentum or identifying divergences. The most common used trend indicators that we will analyze in the following sections are:

MACD – Finding and analyzing momentum

ADX – The strength of a trend

Bollinger Bands® – Volatility and strength indicator

Moving Averages – Directional information, strength and also as support/resistance

#2 Range-bound oscillators

Indicators used in ranging markets are called oscillators, although some trend following indicators are oscillators as well, between they oscillate between 0 and 100 back and forth, whereas the upper and lower end of oscillators are also referred to as overbought or oversold. The oscillators we analyze in our coming sections are:

Stochastic

RSI

Volatility indicators

Independent from range or trend environment, indicators who analyze volatility can be used in combination with other indicators, tools and price action concepts to gather more information about market conditions. The 3 most common indicators that measure volatility are:

Bollinger Bands – Bollinger Bands show the standard deviation (a measure of volatility) around a moving average.

Standard Deviation – The standard deviation is a measurement of volatility levels. Whereas the Bollinger Bands are directly plotted on the price chart, the Standard Deviation indicator goes below price charts.

ATR indicator – Calculates the average range in over the past X periods. A high ATR indicates that recent volatility was large, compared to low ATR readings.

Parabolic SAR – This indicator is diverse and can be used for different purposes. It can be a trend-following indicator, but it’s also commonly used as a trailing stop methodology.

The three signals of indicators

The general signal of an indicator comes in one of three forms.

1. First, when an indicator consists of two lines, the cross-over signal (when one line crosses the other) shows a change in direction and/or momentum.
2. The second signal is falling and rising indicator values which are mostly found in momentum indicators such as MACD or ADX.
3. And the third signal are divergences where indicators and price action do different things (price makes a new high, but the indicator does not)  and signal a potential reversal.

Example of divergence and cross-over signal

Period Settings

The period settings are crucial for how indicators calculate and display data. And, even more important, the period settings of the indicators are responsible for how often and signals are generated and how sensitive the indicator responds to changes in price movements. Thus, choosing the right setting for the specific purpose is essential, but mostly overlooked by traders.

A slow setting indicator includes more past periods and observations into the calculations and, therefore, new price information do not have a great impact. Slow settings on an indicator mean that it takes more time for the indicator to turn around if price changes; the indicator moves more smoothly and is not very sensitive to new changes in price.

An indicator with a faster setting (fewer periods) moves more erratic and is more sensitive to new price changes.

Choosing the correct indicator setting is, therefore, of great importance when it comes to making sense out of the data. Whereas a slower setting can potentially filter out more noise, a trader will also get valid signals later. On the other hand, faster settings produce more signals and also more noise for the trader. The balance and the right objectives are important for choosing the optimal period length.

Fast vs. Slow period setting

Indicators or price action?

The discussion about whether to use indicators or price action is as old as trading. However, once a trader understands that there are no differences between price action and indicators, traders can avoid the typical ignorant mindset and combine tools and concepts in a better and more professional way.

Indicators just take price information and the data you see on your charts and perform a calculation in order to transform it into a visual output. Thus, whether you look at a head and shoulders pattern or a divergence on your indicator, a trader can gather the same information from both concepts; both methodologies are based on the exact same information available.