Navigating the Indicator Maze

There are a plethora of indicators at the modern trader’s disposal. Indicators by their very nature often tend to bring out the rocket scientist in their developers with the mathematics behind them often being complex and challenging to understand. This can be extremely confusing and even intimidating for many new traders. Over the next few paragraphs let’s attempt to navigate the imposing world of indicators using the simplest possible route.

There are a plethora of indicators at the modern trader’s disposal. Indicators by their very nature often tend to bring out the rocket scientist in their developers with the mathematics behind them often being complex and challenging to understand.  This can be extremely confusing and even intimidating for many new traders. Over the next few paragraphs let’s attempt to navigate the imposing world of indicators using the simplest possible route.

When one thinks about indicators, the first questions that often come to mind are:

• Which indicators should I use?
• How do these indicators work? (What is the math behind them?)
• How do I use them effectively?

Let’s look at each of the above questions in turn, and then see how they may be effectively addressed in a trend trading context.

Which indicators should I use?

The choice of indicator is usually defined by your trading strategy.  In other words, use the indicator or indicators that your trading strategy calls for, and unless you are an expert who can design trading strategies, it is better not to do things the other way around, i.e. it is advisable not to begin with an indicator and then build a strategy around it.  Secondly, if faced with a choice between two indicators in a given strategy, it is usually better to go with the one that is simpler and is intuitively easier to use such as the Relative Strength Index in the US 30 Cash chart below.

How do these indicators work?

The good news for traders who do not have an advanced degree in mathematics is that you need to know neither how an indicator works, nor the math behind it in order to use it successfully and effectively in your trading.  However, you do need to understand how the indicator fits in with the scheme of things in your trading strategy.  So, it is more important that you know your trading strategy well, including all of its moving parts, and how they fit together, rather than the inner workings of the individual moving parts.  In other words, to drive a car, you need to know several things including how to operate the gear shift, but not necessarily how the gear box works.

How do I use them effectively?

There are two primary ways in which indicators are used.  They are used to signal overbought and oversold conditions which can indicate a likely market correction as well as to gauge convergence and/or divergence of momentum with respect to the price action.  Also, one needs to be aware of the settings associated with an indicator and how this impacts its behavior.

Most well defined strategies clearly spell out not just which indicators to use but also their requisite settings.  They also clearly indicate how the indicator is to be read in the context of the strategy and whether to use them to gauge overbought/oversold conditions or seek convergence/divergence with prices.

Indicators in a trend trader’s context

At TWP our strategies are trend based and thus we use indicators to identify the directional strength of a trend.  For these purposes we find the MACD and the RSI to be the most effective as well as the simplest to use.  They fit into our strategies by helping is identify the very best trends to trade and also highlight areas of congestion in a trend from which a breakout is most likely.  Our strategies clearly define that the settings with which these indicators are to be used are their standard settings, or so called “box settings”. Based on the way they are incorporated in our strategies, we use them as leading indicators and look for convergence with price action rather than as overbought or oversold gauges.

How do these indicators work?

The good news for traders who do not have an advanced degree in mathematics is that you need to know neither how an indicator works, nor the math behind it in order to use it successfully and effectively in your trading.  However, you do need to understand how the indicator fits in with the scheme of things in your trading strategy.  So, it is more important that you know your trading strategy well, including all of its moving parts, and how they fit together, rather than the inner workings of the individual moving parts.  In other words, to drive a car, you need to know several things including how to operate the gear shift, but not necessarily how the gear box works.

How do I use them effectively?

There are two primary ways in which indicators are used.  They are used to signal overbought and oversold conditions which can indicate a likely market correction as well as to gauge convergence and/or divergence of momentum with respect to the price action.  Also, one needs to be aware of the settings associated with an indicator and how this impacts its behavior.

Thus using the simplest strategy amongst those called for in one’s strategy is a good starting point.  We are better served by being knowledgeable on how an indicator supports a strategy rather than knowing its inner workings.  Finally, the effective use of indicators and whether to employ them to gauge overbought/oversold conditions or convergence with price action is best dictated by the context in which they are used, by the trading strategy employed.

Nilay Guha