Hammering a Lightbulb – Don’t Use the Wrong Trading Tools

Brandon Wendell
Instructor, CMT

Most traders believe that all technical indicators are alike and can simply be substituted one for another.  If you are of that belief then you are probably not using these indicators successfully.  A person who thinks all tools are the same may try to use a hammer or screwdriver to repair a leaky faucet.  They will likely fail at that task.  All they needed was a pipe wrench to fix the trouble but since they poorly assessed the problem and chose the wrong tool, they may have a larger dilemma than when they started.

Trading without a full understanding of the markets and using the wrong tools is something I see often when prospective traders come to Online Trading Academy’s courses.  Fortunately we are here to educate you and guide you in reaching your financial goals.  Our courses are filled with information that you need to learn to properly trade and protect your capital.

Let me get back to the technical indicators.  You have heard me and other instructors stress the importance of price action and supply and demand as the best indication for potential future price movement.  Even though I may have a great knowledge of many indicators and do use a few in my trading, they are only used to support my decisions that are being made on price and/or volume.  The signals generated by these indicators typically come after the optimal entry and confirm that my decision was correct.

There are two types of technical indicators: the momentum indicator and the oscillator.  Knowing the difference and choosing the right indicator for the market environment you are trading in may be just as critical as choosing the right security to trade.  Using the wrong indicator can lead to false or early signals that cause losing trades or scare traders out of winning positions too early.

The momentum indicator as its name suggests, measures the strength of a trend.  Momentum is a measurement of the rate of change in price.  Just like Newton’s Third Law suggests, an object in motion tends to stay in motion.  Building momentum usually suggests continuation of trend.  A decline in momentum suggests a pause or reversal due to opposing forces of buyers or sellers.

Momentum indicators include popular tools like MACD, ADX, Momentum, ROC, Money Flow and a host of others.  Momentum indicators work best in trending markets to gauge the strength or weakness of the trend.  A momentum indicator will yield false signals in a sideways, choppy market and cause you to overtrade.  You must also be careful not to trade against the trend.  For instance, a buy signal generated from a MACD at a support zone in an uptrend is a good entry signal.  However, the sell signal from that MACD may be an indication to take profits, not to short the market against the prevailing trend.

MACD spy snapshot

So if we should not use momentum indicators in a channeling market, what can we use to assist us in price prediction?  Oscillators are a useful tool in that scenario.  Oscillators measure overbought and oversold environments in price.  The problem with this type of indicator is that in a strong uptrend, prices become overbought very fast and can become more overbought before declining.  Selling or even worse, short selling overbought on an oscillator could lead to cutting profits short or losses.  The same happens in a downtrend when oversold leads to more oversold.  Oscillators can be used in trends with some modification which we discuss in the Technical Analysis Strategies course at Online Trading Academy.

An oscillator is an indicator that measures when prices have reached an extreme in comparison to normal, or when price action is changing.  Most oscillators will have an overbought line and oversold line built into them such as 80-20 on a stochastic or 70-30 on an RSI.  When you reach these areas and are at a supply or demand zone, you have a higher probability for success when you act.  The same problem arises with oscillators as momentum indicators in that they may give late signals and you shouldn’t fight the dominant trend for the timeframe you are trading.

bwendell 20140401 - stoch spy snapshot

There is no substitute for price.  Understanding supply and demand is critical for any trader to have success in any market.  However, using the right technical indicators at the right time can definitely increase your probability of being on the right side of the trade.  Make sure you aren’t using a hammer to change a light bulb.  It’s the wrong tool and you’ll make a bigger mess.  Until next time, trade safe and trade well.

Brandon Wendell

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.