Thursday, July 1, 2010

How we Have Been Fooled : An Evaluation of Traditional Indicator Setups

One of the first things you learn when you go into the field of technical analysis is that there are a series of well-defined setups that were used by the fathers of the field to extract profits from the financial markets. It is very hard not to ask if there is really any merit to any of these methods - usually developed around stocks - in forex trading. I had always wondered if there was actually any real profit potential behind the old advice "buy when the RSI is below 30 and sell when it is above 70" or similar indicator based suggestions. On today's post I will talk to you about the potential of entries based on the "standard" traditional indicator setups and if we can really develop profitable systems based on this kind of trading. You will see that traditional indicator rules do not work very well in forex trading and that a deep mathematical understanding of the indicators is necessary to design setups that really work.

I bet you have also wondered if you gain any statistically meaningful advantage by following the textbook advice regarding indicator usage. I certainly believed when I started trading that the traditional indicator setups were the key to achieve profitability. I traded for a few months by using the Stochastic oscillator exactly as the traditional rules indicate (buy when below 20, sell when above 80) but I failed to use this technique successfully for many reasons. The first and most important is that entries do not determine a system's profitability, merely its potential and - not surprisingly - the money management I was using (lot sizing plus exit criteria) did not make up a long term profitable system.

Many years after this happened I continue to wonder, is there any merit to these traditional indicator entries ? Given that now I have the tools to evaluate the mathematical expectancy (please read this article to learn more about my definition and use of mathematical expectancy on entries) of these entries and therefore their potential for the development of a long term profitable system, I decided to do this analysis with 10 traditional indicators and their usual setups. The results confirmed what I had suspected for a long time, there is no merit to traditional indicator setups in forex trading, at least on the forex majors (which are the pairs I evaluated).

Evaluating the mathematical expectancy over 10 to 100 periods on the one hour to daily charts (to get accurate results) showed that these entries have a negative mathematical expectancy, pointing out that there is no merit in the development of long term profitable systems following these trading tactics. The mathematical expectancy increases as you reach higher time frames but almost no indicators have any positive results whatsoever. Perhaps the only one that reaches positive results on some time frames and periods is the Stochastic Oscillator but the positive edge is minimal and overall it would prove to be terribly hard to develop a long term profitable system based on the "traditional use" of this indicator.

In the end I believe this is the exact reason why people always explain how to use these indicators without ever giving you any guidance about the potential of these entries in concrete terms. It turns out that the traditional setups of these indicators do not work very well and therefore anyone building entries based on these traditional notions is bound to end up with - in the best case - a long term profitable system with extremely poor qualities.

It should be clear however that this does not mean that these indicators are useless since through adequate interpretation of the calculations done over price it is possible to design trading strategies that uses them in an effective and powerful fashion (as Watukushay FE so clearly shows). What I am trying to say here is that the development of profitable systems in forex trading using the "traditional trading setups" for most indicators is likely to fail since the potential of these entries - evaluated through their mathematical expectancy - is negative.

So next time you read a textbook telling you that the RSI, Stochastic Oscillator or MACD is used in A or B way, think twice before you start trading or even designing a system based on this knowledge. Mathematical expectancy analysis of entries as well as a true understanding of the underlying calculations made by the indicators are vital to design and trade effective strategies. During the next few weeks I will make up a video on Asirikuy showing all these analysis and how some simple modifications based on sound analysis can dramatically affect the mathematical expectancy of a given entry logic.

If you would like to learn more about automated trading and how you too can design systems with realistic profit and draw down targets please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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