The Truth About Technical Indicators: The Good, And The Bad

The Truth about Technical Indicators in the stock market

It is a bit overwhelming when being first introduced to technical analysis. It can be quite confusing, as a lot of jargon is thrown around. As the years go by, I find myself focusing less and less on technical indicators (chart patterns are much more useful, and I don't mean patterns like Head and Shoulder patterns). I find the indicators out there to not be that effective since they are so overused by trading robots and retail traders thus taking the edge away.

My Thoughts on Indicators

Early in my trading career, I followed Tom McClellan and he has always emphasized not to use the same tools everyone else does, as it takes away the edge. I have always taken that as motivation to find new/unique ways of interpreting indicators. For example, with the RSI, I don't look at it to tell me whether a stock is overbought or oversold, there is so much to the indicator, that many don't discuss (or maybe notice). In fact, I find trying to use it to tell if a stock is overbought or oversold is inaccurate and hard to profit from its signal. Ever notice that when a stock is more overbought, it just keeps getting more and more overbought? That's not a very useful way to exit/short a stock, However, I rather keep the ways I read them to myself, and maintain my edge. The point is, try to think outside the box, even when looking at other indicators, don't just go with the way everyone else reads them.

I cringe when I see people draw wedges and trend lines saying “here’s a great setup”. Sure these setups work once in a while but often the stock just trades sideways going nowhere. Remember, just because something works once in a while doesn’t mean it’s profitable. It’s kind of an insult to think that the market can be simplified by drawing lines on a chart. Where in reality it’s thousands of forces coming together giving the appearance of random movement with a bias towards trending higher (the market always goes higher as time passes).

It's important to understand the edge in everything you are doing, i.e. if you want to trade trend line setups you need to make sure it actually has an edge. Remember the key to trading is to beat the buy and hold strategy. So if you are making money it’s not enough it’s about making more than you would if you just held.



My Top 2 Indicators

My top 2 favorite indicators are RSI, Bollinger Bands. RSI is a very accurate way to represent price without all the noise. Basically, it measures how the speed and change of price movement, you can read more about the RSI here.

My absolute favorite indicator is Bollinger Bands. I cannot trade without them.

From Wikipedia:

Bollinger Bands consist of:
  1. an N-period moving average (MA)
  2. an upper band at K times an N-period standard deviation above the moving average (MA + Kσ)
  3. a lower band at K times an N-period standard deviation below the moving average (MA − Kσ)

In short, it gives a range of what is statistically possible in terms of price. So 95% of the time, the price of a stock should be inside the bands. Therefore, being outside the upper or lower band is one of the most reliable ways you can tell if a stock is overbought or oversold. However, this isn't always the case, especially during an earnings movement or surprise news event surrounding the stock. As an example, the chart below is AAPL and is Bollinger Bands. Note how often the Bands acted in areas where the price would bounce from! But not always!


There are plenty of video tutorials on interesting strategies on how to use Bollinger Bands. I have written an article dedicated to helping you master Bollinger Bands. Hopefully, the article will help you think outside the box and create/maintain an edge!



Japanese Candlesticks

Every stock trader and investor should be comfortable reading Japanese Candlesticks. Flat out, they are the most reliable predictor of future prices. I've written an introduction to candlesticks in Mastering the Art Form of Japanese Candlestick Reading. It's a good tutorial to truly understand Japanese Candlesticks. 

Combining Japanese Candlesticks and Bollinger bands is a killer combination of a high probability setup. For example, if you encounter a stock that has lost about 30% from its highs, and is sitting right on its lower Bollinger Band, with a hammer candlestick, the stock will likely bounce hard. Just take a look at the example below using Apple's weekly stock chart.

Apple Stock Chart upper bollinger band hammer candlestick example

I discuss various tips and tricks regarding Japanese Candlesticks and my favorite patterns in this article here. Keep in mind technical analysis is most reliable when you have a cluster of signals, in the example above it's the stock hitting the lower Bollinger band, as well as the formation of a bottoming hammer candlestick. Both of these signals indicate a bottom is forming, which means a bounce may occur. That is the type of setup you want to look for. 


Conclusion

I wrote this blog post to inspire people to focus on Bollinger Bands and RSI to try to find new, innovative ways to use them compared to the current crowd.

For the dedicated reader feel free to explore the Market Education Library on this site, which includes countless articles on various indicators, giving you hints and tips on applying them and making money.

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