Evaluating Market Momentum

“I have two basic rules about winning in trading as well as in life:

1. If you don’t bet, you can’t win.

2. If you lose all your chips, you can’t bet.”

- Larry Hite

Technical trading is all about tipping the reward side of the risk-reward equation in your favour. To this end, indicators are one handy set of tools that can help potentially realize positive outcomes.

What are Indicators?

In technical analysis, indicators are used to forecast market direction. They are mathematical calculations that can be based on historical prices, volume, or a combination of both. Indicators are an integral part of technical analysis and are either overlaid on a price chart or plotted below. Indicators are typically back-tested on historic price and volume data to test their effectiveness in predicting future market direction.

Technical indicators can be broadly classified into four categories:

1. Trend Indicators – A trend is the general direction the price of an asset is moving. Trend indicators try to identify market trends and pinpoint potential “buy” and “sell” zones. The Simple Moving Average (SMA) and the Exponential Moving Average (EMA) are the two most popular trend indicators.
2. Momentum Indicators – Momentum indicators measure the rate at which the price of an asset is changing. Widely used momentum indicators include the Stochastic Oscillator, Relative Strength Index (RSI), and William’s %R.
3. Volume Indicators – Volume indicators are employed to confirm the strength of a price trend. Lack of confirmation often results in price reversals. The most popular volume indicators include On Balance Volume (OBV), Accumulation-Distribution, and Money Flow Index (MFI).
4. Volatility Indicators – Volatility indicators measure an asset’s price swings. Periods of high market volatility are typically followed by lower volatility phases, and vice-versa. Bollinger Bands, Average True Range (ATR), and Keltner Channels are examples of common volatility indicators.

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What do Indicators Tell Us?

Technical indicators provide traders with a realistic framework for decision-making. Instead of buying and selling based on hunches and rumours, indicators represent a more mathematical approach to analysis. By looking at price trends, momentum, volume, and volatility, traders can gain additional perspectives on how prices are changing, which, in turn, can form the basis for entering and exiting trades.

Why are Indicators Useful?

Technical indicators are analysis tools that investors and traders can use to scrutinise past prices and forecast future price action. Whereas fundamental analysts track economic reports to form their strategies, technical traders generally rely solely on indicators to help interpret financial markets. The ultimate aim of technical indicators is to identify potential “buy” and “sell” locations on a price chart.

For example, a crossover between two Simple Moving Averages is often followed by a trend change and represents one of the most basic technical trading signals. Therefore, by overlaying the moving average on a price chart, traders can spot areas where the trend is likely to change direction.

An advanced form of technical analysis is employing “strategies” to determine entry and exit rules. A technical trading strategy is a set of rules that defines how trades will be opened and closed. Typically, strategies include the detailed use of one or more indicators to focus on areas where the likelihood of realizing a successful trade outcome are greater than normal.

A major advantage of using indicator-based strategies to trade and invest is that these techniques can help reduce the chance of our emotions impacting the decision-making process.

What are the Drawbacks of Indicators?

The most common mistakes that novice traders make when using indicators is using too many to generate “buy” and “sell” signals. “The more, the merrier” may be true in other aspects of life, but that rule doesn’t necessarily apply to trading.

Following too many indicators can lead to “analysis-paralysis”. Studies have shown that limiting the number of indicators to a maximum of 5 can help optimize trade results.

Another common beginner mistake is using multiple indicators that focus on the same characteristic of changing prices, like momentum. This can result in redundant signals.

Traders should ideally select indicators that balance each other well without providing redundant results. For instance, a useful strategy might include both a trend indicator and momentum indicator to generate trade entry signals.

A Few Thoughts on Indicators

Hundreds of technical indicators are designed to help you form a better grasp of changing market conditions. However, it is easy to use too many indicators or to use them inefficiently. Furthermore, it’s important to understand the limits of using past performance to forecast future prices. To benefit most from these marvellous analysis tools, success ultimately depends on avoiding information overload and learning to optimize indicators.

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*MetaTrader 5 is not available for clients under ForexTime UK Limited.