Avoiding a Trading Tragedy
Out of intense complexities intense simplicities emerge.
If you are reading this book, you are probably a technical trader. You may have spent time, money, and effort learning about indicators. You may have learned through experience that trading with indicators can be very difficult. In some ways, trading with indicators makes it difficult to find profits. Perhaps a close look at why indicator-based trading systems have difficulty finding profits in forex is in order.
All indicators are created from price data. This is what all indicators do to price data: Price data enters into an equation and is spit out as something else. Sometimes the end product is a squiggly line, sometimes a straight line, sometimes a color or a number; it depends on the indicator. The end result is always the same: The indicator changes price data via a formula.
The form of this end result (the indicator) may vary, but the process is always the same.
These very same indicators, based on price data, are meant to hint at future movements in the market. Stated another way, an indicator will suck in price data, massage and process these data, and then spit out a graphical representation of these data. Indicators offer price data in another form.
Perhaps this new form of price data is easier to interpret; perhaps this new form of the price data will hint at what the market may do in the near future. All indicator-based trading systems are founded on the idea that price data is in a better form when presented as an indicator. Trade decisions based on indicators assume that the data in indicator form is more valuable than raw price data.
I N D I C A T O R
A metric derived from price data. Historical price data—such as the open, close, high, and low—are entered into a formula to calculate the metric. This metric is then represented graphically to anticipate and interpret market movements.
Traders want to know where price will go in the future. Traders pay millions upon millions of dollars for educational seminars, DVDs, website lessons and, yes, even books such as this one. The great hope for most traders is that there is a valuable indicator (or recipe of indicators) that will hint at where the market is headed in the future. Millions upon millions of dollars are spent each year by traders (and also investment companies, hedge funds, banks, etc.) because a slight edge may provide millions of dollars in profits. In forex a slight edge may mean billions of dollars in profits.
IS THERE A “BETTER” INDICATOR?
Which indicator is best? Which suite of indicators offers a clear edge in the markets? Perhaps it is best to find out who is making money in forex, and then do what they do. Which is the magic formula? Unfortunately, the answer to this question is “It depends on who you ask.” This may very well be the correct answer. As we will see later in the book, trading is often relative and rarely, if ever, a one-size-fits-all endeavor. Some indicators are considered shams, others are misinterpreted by the masses, and still others are best used contrary to their original design intent. Indicators may be incorrect. What if the indicator is correct, but a bit slow to hint at the direction the market will take? The indicator might provide valuable information, but might also be slow to the party, and thus not of much value.
Perhaps a slight change to the indicator formula will speed it up a bit. Perhaps indicators are similar to a wristwatch, constantly improving, more features available as needed, but would it be possible to take a wristwatch, and manipulate time by running a formula through the hours, the minutes, and the seconds displayed on the wristwatch? Would the wristwatch keep better time once the formula manipulated the actual time of the day?
Using a formula to create a better time on a wristwatch may seem weird and counterproductive, but this is precisely what indicators may accomplish by changing and massaging price data. Indicator-based trading is taking a wristwatch and changing the time with a complex formula in the hopes that the wristwatch will somehow tell time better. Who wants a wristwatch with something other than the real time displayed? Do indicators (all of which are calculated using price data) allow us to understand price better?
Perhaps it is best to put aside any philosophical differences with technical indicators. Let us assume that our indicator is based upon a magical formula and this formula allows us to get a glimpse of the future. Our indicator magically transforms price data into some other number, color, or line, and suggests where price is headed in the near future. Unfortunately, even if our indicator is able to accomplish this, difficulties may endure with indicator-based trading.
Indicators are inherently slow. The market will be moving up long before an indicator suggests it is time to buy. Likewise, an indicator will suggest it is time to sell long after the market has started falling. This is one of the main complaints with indicators: they lag behind price. This is a fair concern. Figure 2.1 contains an AUD/USD four-hour chart with the Relative Strength Index (RSI) indicator. Traditionally, there are two RSI signals. If the RSI is above the 70 level, the market is overbought, and once the RSI falls back down below 70, a sell trade is initiated.
Likewise, if the RSI falls below 30, the market is said to be oversold, and, traditionally, a buy trade is signaled once the RSI moves back above 30 (see arrow in Figure 2.2).
In these examples we see that the RSI indicator suggests a trade at about the right time. The market turned around near the RSI signal in both examples. However, the RSI did not signal a trade at the precise turning point in the market. To find these turning points, an indicator of a different type is required. One of the primary reasons why naked trading is so attractive to forex traders is because naked trading allows for early entries into trades. Indicators may alert traders to the fact that the market has turned around after the market has turned around, but naked traders may find turning points in the market as they occur. Naked trading strategies are based on the current price of the market, and, therefore, they allow for an earlier entry. Indicator-based trade signals will lag because it takes time for the price data to be processed through the formulas that make up the indicator.
Significant moves in the forexmarket occur before a technical indicator provides a signal.
Naked traders have an incredible advantage. Entering a trade early often means the entry price is closer to the stop loss price. A tighter stop loss may mean more profits, the precise reason for this is examined later in the book. After mastering a few simple strategies, naked traders find it very difficult to move back to indicator-based strategies simply because naked trading strategies remove the lag time that is inherent with indicator-based trading.
Here is another example, this time with the EUR/USD daily chart (Figure 2.3). In this example the indicator at the bottom of the chart is the Moving Average Convergence Divergence (MACD). The construction and theory behind the MACD is not important, the MACD consists of a few moving averages. The critical signal for the MACD is when the two moving averages cross (see the dark circle in Figure 2.3). A traditional buy signal occurs when the MACD has been traveling lower for some time and then turns around, and the faster-moving average crosses the slower-moving
In Figure 2.3 the EUR/USD daily chart has been falling for some time. Price starts to turn around and trade higher, and consequently the MACD moving averages start to creep upward. Finally, we see the faster-moving average on the MACD has crossed above the slower-moving average. This signals a buy trade for the MACD trader. After crossing upward on the MACD, the market does indeed move higher (see Figure 2.4). Although this trade looks like a nice trade, the naked trader would have entered this trade earlier than the trader using the traditional MACD trading strategy. The naked trader and the MACD trader both profit, but the naked trader is able to enter the trade sooner and use a tighter stop loss.
Tighter stops mean more money. The naked trader and the MACD trader could have both exited at the same price, but the naked trader captures more profits because the stop loss is placed closer to the entry price. The money-management section of this book will have more information on how naked trading strategies enable traders to make more money simply because naked signals appear earlier than indicator-based trading signals.
The MACD and the RSI are not the only indicators that lag. All indicators lag. The stochastic is a popular indicator used to time trades according to the natural rhythms of the market. One traditional stochastic trading method is similar to the RSI strategy. A sell signal is indicated when the stochastic falls below the 30 level and then crosses higher (see Figure 2.5).