1. First hand vs. second hand data…
The root of the problem with using indicators to analyze the forex market lies in the fact that all indicators are second-hand; this means that instead of looking at the actual price data itself, you are instead trying to analyze and interpret some variation of price data. Essentially, when traders use indicators to make their trading decisions, they are getting a distorted view of what a market is doing. All you have to do is remove this distortion (the indicators) and you will obtain an unobstructed view of what price is doing in any given market. It seems easy enough, yet many beginning traders get suckered into clever marketing schemes of websites selling indicator based trading systems, or they otherwise erroneously believe that if they learn to master a complicated and “fancy” looking indicator they will for some reason begin to make money consistently in the market. Unfortunately this could not be further from the truth, let’s begin by looking at the two main classes of indicators and discuss why they are flawed:
• Leading and Lagging indicators…
Technical chart indicators come in two different forms; they are either “lagging” indicators or “leading” indicators. Lagging indicators are also known as “momentum” indicators, the most popular lagging indicators are MACD and moving averages. Lagging indicators claim to help traders make money by spotting trending markets, however, the problem is that they are “late” to the ball, meaning they fire off a buy or sell signal into a trending market after the market has already started to trend, and just as it is probably about ready for a counter-trend retracement.
The other problem with lagging indicators like MACD and moving averages is that they will chop you to pieces in consolidating markets; firing off buy and sell signals just as the market is about ready to reverse and re-test the other side of the trading range or consolidation area. So, essentially, the only real use that lagging indicators have is in helping to identify a trending market, and I do actually use certain moving averages to aid in trend identification. Check out my price action trading course to find out exactly how I implement moving averages with my price action setups, they are the only indicator that I use and I do not use them for anything other than identifying dynamic support and resistance areas.
Leading indicators include such popular ones as the stochastic, Parabolic SAR, and Relative Strength Index (RSI), these are also known as “oscillators”, because they oscillate, or move, between a buy signal and a sell signal. The problem with these leading indicators is that they work horrible in trending markets because they show “over-bought” and “over-sold” conditions nearly the entire time the market is trending. So, if a market is in a strong uptrend, an oscillator will show the market as being over-bought for the majority of the uptrend, even if it continues rising for a great deal of time. The opposite is true in a downtrend; oscillators will show over-sold conditions almost continually in a downtrend.
This means that these “leading” indicators try to get traders to pick tops and bottoms; an over-bought or over-sold condition implies that the market is due for a correction, when in fact this may not be the case. The problem is that no one ever knows how long a market will trend for, so you are going to have a ton of false signals before the actual top or bottom of the market occurs. And guess what? It is often the exact top or bottom that is showed in examples of these oscillating indicators by people who are trying to sell indicator-based trading systems. They don’t show you the numerous losing signals that were fired off leading up to the actual top or bottom however.
So, because we have lagging indicators that work ok in trending markets but terrible in consolidating markets, and leading indicators which work ok in consolidating markets but terrible in trending markets, many traders try to combine them on their charts in order to use them to “filter” each other. You can probably guess what results from the combining of numerous opposing indicators all over your charts; a heap of confusion and mess that causes second-guessing, doubt, over-trading, over-leveraging, and every other emotional trading mistake you can imagine.
2. Clean charts vs. messy charts…
Let’s take a look at the way many traders try to trade with lagging and leading indicators all over their charts, and then let’s compare this to trading with nothing but a plain vanilla price chart and price action.
Below is the EURUSD daily chart with some of the more popular indicators; stochastic, MACD, Parabolic SAR, and a few moving averages. You can quickly see just by looking at this chart how confusing it is, and you can also see that there are a lot of unnecessary variables on this chart. There is simply no reason to make trading more difficult than it is, but having all these indicators on your charts does exactly that:
Now let’s look at the same chart with no indicators at all, there is nothing but pure price action and a couple of horizontal lines drawn in to show significant support and resistance levels. It’s obvious this chart has less clutter and less confusion, all it shows is the natural price movement in the EURUSD. By learning to read this natural price movement and the conditions it occurs in, we can trade in a very simple yet effective manner.
It is also worth noting that due to the fact that there are no indicators underneath the price, like the MACD and Stochastic in the above chart, you have a completely uninhibited view of price which allows for a less distorted and larger view of the price action than if you had multiple indicators taking up the bottom portion of your screen as can be seen in the chart above.
As we can see in the above two images, the clarity that you get when trading off indicator-free, pure price action charts, is very obvious and significant. Being focused is very important as a trader, when you have 5 different indicators on your charts all telling you conflicting messages, this simply does not contribute to a focused and clear mindset, but rather it induces confusion and indecision.
Having less parameters to analyze causes your brain to work more efficiently and allows you to rely more on your own natural trading instincts. These trading instincts become fine-tuned and fully developed when you learn to read price action on a “naked” price chart, and as you become a more proficient price action trader eventually you will develop the ability to make trading decisions with increasing degrees of accuracy and less effort.
4. Taking a closer look at two popular indicators…
Let’s actually dissect two of the more popular indicators out there; Stochastic and MACD, and then compare them to trading with pure price action.
The Stochastic indicator:
“There are two components to the stochastic oscillator: the %K and the %D. The %K is the main line indicating the number of time periods, and the %D is the moving average of the %K.
Understanding how the stochastic is formed is one thing, but knowing how it will react in different situations is more important. For instance:
• Common triggers occur when the %K line drops below 20 – the stock is considered oversold, and it is a buying signal.
• If the %K peaks just below 100, then heads downward, the stock should be sold before that value drops below 80.
• Generally, if the %K value rises above the %D, then a buy signal is indicated by this crossover, provided the values are under 80. If they are above this value, the security is considered overbought.” (The above information about the stochastic oscillator is quoted from investopedia.com)
The MACD indicator:
“To bring in this oscillating indicator that fluctuates above and below zero, a simple MACD calculation is required. By subtracting the 26-day exponential moving average (EMA) of a security’s price from a 12-day moving average of its price, an oscillating indicator value comes into play. Once a trigger line (the nine-day EMA) is added, the comparison of the two creates a trading picture. If the MACD value is higher than the nine-day EMA, then it is considered a bullish moving average crossover.
It’s helpful to note that there are a few well-known ways to use the MACD:
• Foremost is the watching for divergences or a crossover of the center line of the histogram; the MACD illustrates buy opportunities above zero and sell opportunities below.
• Another is noting the moving average line crossovers and their relationship to the center line.” (The above information about the MACD is quoted from investopedia.com.)
From the above two descriptions of the Stochastic and the MACD indicator, we can see it almost hurts your brain physically to read all the parameters involved in calculating them and how exactly they are to be used. The over-arching theme of such indicators is that you have to follow specific rules to use them. This means you have to be sitting in front of your computer waiting for the indicators line up exactly right before entering a trade. Many traders combine 2 or more indicators and require multiple signals to “line-up” on each indicator before taking a trade. You can see how quickly this jumble of messy and overly-complicated lines, colors, and signals all over you charts can confuse you and even cause you to panic in frustration. I actually got a headache just doing the research for this article because I know that indicators like these are so pointless and unnecessary that it hurts my brain to think about it.
Let’s now look at a couple examples of charts with the Stochastic and MACD indicators on them compared to the same chart with no indicators but only price action setups marking the important trading signals.
Now compare the above chart to the exact same chart below with nothing but pure price action setups and support and resistance levels marked. It becomes clear when you do an exercise like this that trading off pure price action is much more logical and advantageous than trying to draw the same ultimate analysis from something OTHER THAN price. Why would you try to analyze squiggly lines that are derived from the “core” price data when you can learn to analyze and trade successfully off simple price action setups which actually ARE the “core” data? Too put trading with price action in the context of a sales metaphor; you are cutting out the middle-man and buying directly from the producer.
The chart below is a daily chart of gold. Notice how the Stochastic indicator was showing an over-bought condition for multiple months in 2010 during what was a very strong and vigorous uptrend full of many profitable price action entries. If you were a follower of the Stochastic indicator you would have constantly been thinking the top was in because you would be looking everyday at your indicator that was telling you the market was “over-bought”. This is proof that the only thing that matters in any financial market is what the price action is telling you, not what some mathematic equation is predicting “should” happen. It is common knowledge after all; that what “should” happen in a market is not often what “does” happen, unless it is tipped off by price action.
Now we see the same chart above with only price action:
The arrows in the chart above each mark a price action setup that I teach, if you had been trading this uptrend in gold last year you would have obviously been much better off just trading the price action rather than trying to over-analyze and over-complicate everything with a bunch of messy indicators all over your charts.
If it is not extremely obvious by now why price action trading is a far superior forex strategy than any indicator-based strategy, it should be. If you want to truly understand price dynamics and the mechanics of financial markets, you need to learn to analyze price action on an indicator-free price chart. Even if you don’t go on to become an expert price action trader, you still need to have a solid understanding of how to analyze a “naked” price chart and how to trade with nothing but price action and important levels in the market. If you end up using some other trading strategy or system, your knowledge of price action and how to trade it will only make that strategy or system more effective.
The bottom line is that indicators make you lazy because they lull you to sleep in believing you don’t really need to do any work or learn anything besides how to read your “mechanical” indicators that will tell you what to do and when to do it. Price action is great because you can form decisions about future outcomes and direction with greater accuracy and speed than any other trading method because price action is the most current market analysis tool there is. Eventually your brain and subconscious will sync up together and trading off pure price action setups will be like riding a bike; once you adapt to it you will be able to ride it very well and it will become like second nature. Price action is the most clean and logical way to analyze and trade the forex market, learn to trade off price action sooner rather than later if you want to get your trading on the right track.