Hi guys, hi from Andrea Unger! Today, I’d like to talk about indicators in trading systems. Are they effective? And what precautions should we take when we use them?
People often ask me what indicators I use in my trading systems, and if there is one indicator that I think works better than others.
I never use indicators in trading systems as a setup or to make decisions. I also never use them to mix information together in order to get a level and timing to enter the markets.
Why not? Because I’ve never found an effective solution to this approach. I’ve never found a way to get a decent performance report using indicators to define where and when to enter.
Indicators “indicate”, this is the very meaning of the word. So, they can give us an idea of what is happening, but they provide no detailed information about it. They are an average value of different situations.
If you really want to use indicators in trading systems, I suggest that you consider using them only with wide enough timeframes on your charts, starting at least from 30 minutes.
Here is the reason. Indicators are built resting upon the prices in your bars. However, the market noise can affect data, if you work on short timeframes. Let’s make an extreme example. Suppose you work with one-minute bars and build your indicator on the close of the bar; the position of the close of a one-minute bar can make a great difference in percentage on the range.
If you move it by one, two or three ticks, the exact position of the close of the minute you are plotting on the chart changes. It’s actually random, as it can be one, two or three ticks above or below.
We can’t obviously identify the right tick. We only know that a move of one, two or three ticks, compared to the range of a one-minute bar, is very relevant in percentage.
On the other hand, if we work on one-hour bars, i.e. on sixty-minute bars, a move of one, two or three ticks has less effect on the whole information we get. This applies to the indicators you build using not only the close of bars, but also the high, low, open or whatever.
Of course, the randomness of prices that is due to the market noise can have a dramatic impact on indicators. This is the reason why, if you want to use an indicator and you have clear information out of what you’ve plotted, you need to use a larger timeframe. This is my personal opinion; however, the results I got throughout my tests and research confirm it’s better to work on large timeframes when you want to use indicators.
That being said, I don’t use indicators as setup or trigger tools, but I use some as filters. I prefer to enter based on patterns, breakout or countertrend, and concepts of very basic levels, such as the higher of yesterday or the higher of today. Then, I can add an indicator to filter entries.
My favourite one is the ADX. For instance, I avoid entering and drag out when the value of the ADX is too high. A high ADX value indicates that there has already been a pretty strong acceleration in the moves of prices, and I found out that, normally, the response to a breakout after an already existing acceleration is weaker or even not effective at all.
So, I prefer to enter at breakout when the situation has been calm enough before the breakout happens, which means the ADX should have lower values. Personally, I use 40 as a threshold, but you can test your own values.
Another indicator I sometimes use is the moving averages. I use it as a trend indicator, which means that, for example, I go long only if we are above this moving average and short only if we are below.
Getting back to the ADX, some people claim it’s possible to get similar benefits using the RSI oscillator. I prefer the ADX, however, as I didn’t observe any particular benefit. Anyway, it might be a solution.
To conclude, I don’t base any setup or trigger on indicators or oscillators in my personal trading. I just use them as filters, if I decide to use them, and always with large timeframes. I never plot indicators on a five-minute chart. The pieces of information it can deliver are too poor and can contain some errors that are due to the impact of the noise in the markets on smaller timeframes.
That’s all about indicators. If you have any question or suggestion, write a comment.
I hope it was useful.
See you next time, ciao from Andrea Unger!