And what to do about it
If you’re a new trader, it can be frustrating and overwhelming to process all the tools available to you. Using indicators in trading are just one avenue to help you make an informed trade. But traders seeking to make informed decisions about a potential position should be very careful before blindly putting their faith into any one particular tool. In this article, we discuss some of the potential pitfalls of using indicators, and what you could do to avoid them.
Many Indicators are Scams
If it sounds too good to be true, it probably is. Though this may sound so banal that it has become cliché, traders (especially newbies) should pay heed. Many new traders want a ‘magic’ indicator that simply tells them when to buy or sell. There are plenty of charlatans out there on the internet who are more than willing to take advantage of this. Beware of anyone selling an indicator without fully understanding how it works, or why. This is not to say that there aren’t great proprietary indicators out there, but it may take some trading experience to differentiate these from the noise. After all, if these ‘magic’ indicators worked so well, the authors would not need to be selling them to you in the first place!
The solution is to understand that trading is not so clear cut as to be encapsulated by a single indicator or even a combination. If you are a technical trader, and you’d like to learn how to use indicators, start by learning the basics. Choose from one of the most common indicators, e.g. Moving Averages, MACD, RSI, Bollinger Bands, ADX, ATR, OBV, or the like to get started. Once you’ve mastered one, you can get fancy with more advanced tools.
Most Indicators are Just ‘Fancy Moving Averages’
Most indicators really just summarize what is already on the chart. They really just ‘do math’ on the data that is already there. As such, you’re really not gaining any new knowledge about the asset, just seeing it presented in a different way. This is why indicators in general have often been called ‘Fancy Moving Averages’.
Furthermore, since most indicators just manipulate the data in the chart, they often have an inherent lag. This means that the indicator is summarizing what has happened in the past and presenting it to you now. This means that by the time the indicator has registered a signal, it’s already too late.
The solution to this is to use indicators that minimize lag like the KAMA indicator. Some indicators are actually forward-looking. Examples of forward-looking indicators are the Ichomoku Cloud, and Fibonacci levels.
Confirmation Bias: Psychology Strikes Again
All new traders struggle with the psychological game. This will not change. Even the most experience traders grapple with this aspect every day, and it is a mental war to not lose focus during times of market mayhem, being underwater in a trade, resisting the urge to have FOMO, etc. Indicators are supposed to help us with this aspect of trading, but if we aren’t careful a lesser-known psychological pitfall may creep up: confirmation bias.
Have you ever had a really good trade going about a new strategy? “Great!” you think, “I must be on to something!”. You may even have a run of successes. But in the end, often our strategy gets pummeled by changing market conditions. The problem is we fall victim to a confirmation bias, which is a fancy term for the fact that we want our strategy to work so bad, that we don’t fully test it against all possible scenarios, especially the ones that could prove it wrong.
The solution to this is to employ good risk management. No matter how good your new signal or indicator is, make sure you set realistic profit targets and stop losses. Remember that you’re reward to risk ratio should be 3 to 1, meaning that for every pip or tick or dollar I risk, I should get three or more in return if the trade works out the way I planned.
Indicators can be useful for traders, both new and seasoned. Like any tool, they require diligence, effort, perseverance, and a lot of work to master. Even then, the markets are always able to provide us with situations we have yet think about. That’s why it is very important to understand some of the pitfalls of trading with indicators. In this article we presented three such shortcomings and what to do about them. After all, it is better to learn from the mistakes of others up front, than be condemned to repeat them… often at great cost.