When it comes to technical analysis, the range of indicators available means there’s bound to be one to suit every trader. While this is true, most traders unfortunately take this to mean that more is better, which is not often the case.
Technical traders are generally divided into two groups – price action traders and indicator-based traders. Price action traders believe that price contains all the necessary information to predict where the market is headed, whereas indicator based traders believe indicators provide a clearer picture of the underlying market.
New traders generally tend to at least start their trading lives as indicator-based traders. Due to the wealth of information on the different ways that you can trade available on the internet, new traders are pre-conditioned to using an indicator when trading the market.
During my career trading the forex market I’ve seen my share of technical traders loading indicators over indicators to their charts. Not surprisingly, when asked why they’re doing this the answer many give is: “So I can get extra confirmations”.
Now, up to a point that makes some sense – however, the real world trading environment can be a harsh place. Instead of receiving extra confirmation, many traders receive conflicting information – and to make matters worse the underlying market condition is obscured by these indicators. The trader then becomes confused, which doesn’t lead to a positive trading experience.
Proof of the Pudding
Have a look at the chart below
Figure 1, Indicator overload- obscuring the underlying market
The example above is pretty common amongst new traders, especially the combination of having MACD, CCI, RSI and Stochastic. MACD, CCI, RSI and Stochastic all fall under the heading of Momentum Indicators, and they all serve the same purpose; that is to identify the momentum of the market.
Although having extra indicators to confirm one another is a sound intention, the example above clearly demonstrates that on default settings of 14 periods something is a little off – and using so many indicators is unnecessary. The CCI, RSI and Stochastic are mirroring each other, while the MACD is slightly behind. Not only is there data redundancy – with CCI, RSI and Stochastic more or less plotting the same thing – the MACD lagging behind could cause uncertainty rather than added confirmation.
Most traders will wait for all 4 to be synchronised before pulling the trigger; however, since these come so far apart, the frustration of missing out when the market moves often leads to bad trading decisions.
The Right Number
What is the right number of indicators? And how many are too many?
The correct number of indicators will vary from trader to trader; the trick is to use one to suit each purpose.
Let me give you an example: a trader wants to know where in relation to the trend the current market is following or reacting to, how strong is the momentum of the trend, and what is the estimate range for the current period. The simplest combination would be a 200 Simple Moving Average for trend detection, ADX (average directional index) for trend strength and Average True Range to get a range estimate.
The chart below is the end result:
Figure 2, Uncluttered and Straight To the Point Information
The chart above is not cluttered with unnecessary information and conflicting data; it is clear and concise on the information it can provide.
Disclaimer: I don’t use this combination myself. This chart is an example for educational purposes only and can be interpreted as such; EUR/USD 1 Hour is still in an uptrend as price is trading above the 200SMA; range for the current period is estimated to be around the vicinity of 13 pips; and the momentum is slightly lacking at the moment as ADX is below 25.
As you can see, trading is not some action movie where the more weapons you have, the better – and by simply firing in the general direction of the villain you save the world. Trading has a bit more finesse to it. Think of the concept of minimalism in decoration, where less is more!
There is no set rule as to how many indicators on any one chart, but on average traders require the trend direction, momentum of the market and most importantly entry and exit. So base your selection of indicators around this need.
In conclusion, don’t be an indicator hoarder. With summer approaching do some spring cleaning to the number of indicators you use. I will provide a more in depth look into some of the more common indicators in the coming weeks, and if you have any questions don’t forget to fill in the Ask The Expert form, and I’ll come back to you!