Lessons from the Pros


Two Perspectives – One Meaning

I have lost count of the amount of times somebody has asked me what the single best indicator in technical analysis is. Up until the point of asking that specific question, it is usually the case that the person has already tried and tested pretty much every indicator and trading technique which they could get their hands on, a story which unfortunately is most common amongst traders worldwide. As I have often written in the past, it is not the fault of the trader to try out all these different methods because they are encouraged to by the amount of free information on the web today and books available to buy from the stores out there. However there is hope for the market speculator who is determined to search for ongoing consistency in their trading activities, yet it is not typically the answer or solution which they really want to hear.

Without a shadow of doubt, any disciplined objective trader out there will more often than not tell you that the very best indicator that anyone can use is simply price itself. If you know how to objectively read a price chart, it will tell you all you need to know, from where to get into a trade, where to get out for profits or a small loss and from time to time, when to actually not even place a trade. Price always leads everything else. Any other technical indicator we can place on our chart is nothing more than a derivative of the actual prices which have been trading in the past and what are trading right now. If the market is shut and prices are not moving, then obviously the technical indicator itself will also be static. The fancy calculations and formulae used in the indicator itself are a useless empty shell if they are not given price data to work with. Therefore, we have to recognize that if price is the key component or fuel for the indicator, it then has to be the most important piece in the trading puzzle. As you may already know, here at Online Trading Academy, we focus on teaching our students and Grads a simple rule-based methodology which is formed around price itself and the only dynamics which will ever cause prices to move in any marketplace: Supply and Demand, or the willingness of people to buy and to sell and specific times.

With this in mind, does this therefore mean that all technical indicators are useless to a trader and should be ignored? My answer is absolutely not but only if the trader using the indicator, fully understands why they are using it and how it relates to the price in the correct context. An often interesting fact about indicators too, is that there are so many of them to choose from. No wonder why people are always looking for the right one to use! Considering that there are so many indicators it should not be surprising to find that many of them do the same thing as well, or at least tell the trader the same thing but in a different format. The disciplined trader would only ever use the indicator in conjunction with price action and know exactly how to get the very best out of it.

Let’s take for example two of the most popular technical indicators around, specifically the Exponential Moving Average and Bollinger Bands®. When placed on the price chart, they do look very different however there are also very distinct similarities between them too. The EMA is a simple tool which measures and shows the trader the average price of an asset over a pre-determined period of time. This is plotted as a dynamic line on the chart like below, against the USDCAD currency pair: 

The green line you can see is a 50 period EMA. What I would like to draw your attention to is the way that the candlesticks move above and below the EMA line. I have drawn a series of orange arrows on this chart to illustrate times when price attempts to pull away from the green moving average line. I want you to imagine that these candlestick bars have invisible springs attaching them to the EMA. The further the bars try to move away from their average price, the faster they seem to get drawn back to it. This is the dynamic of reversion to mean. The more over-extended price becomes, the more it needs to revert to its average.

Another way to see the same thing is via Bollinger Bands®, which measure the same thing but in a slightly different manner. The bands plot the predicted range of price based on its current average, using plus and minus two standard deviations (this is the default setting used by the inventor of the Bollinger Bands®). The theory then is that when price trades and moves outside of its predicted range, it will have to revert back to its average at some point. This extension of price is represented by a piercing of the bands either to the upside or to the downside. See the chart below for the same USDCAD chart but now with the Bands instead of the EMA: 

Much like the EMA chart before, we can see that the bands show a clearer illustration of price being “over-extended” by the actual piercing of the bands themselves, instead of the way that the bars pull away from the EMA. While the graphical representations of these 2 technical indicators are quite different, they are actually telling the very same story: When price becomes imbalanced to a high degree, it will revert to its average.

Finally, I am now going to show you the same chart but with both indicators removed and a few zones of Supply and Demand shown: 

While not quite as obvious to the untrained eye, levels or supply and demand when recognized objectively, will offer the rule-based trader low risk, high potential reward trading opportunities time and time again. I would always rather use price itself to show me a trading opportunity, instead of a tool which is based on price. However, using a technical indicator in the way it is meant to be used, can be a great way to gain a solid understanding of price and how it behaves. No matter what way you look at it, price changes are governed by pure supply and demand coming into the market. When the imbalance between these two competing forces becomes most out of balance, price has to revert to its mean no matter what way it is shown on a price chart. The disciplined, consistent trader simply finds their way, forms a plan and executes their trades with precision. I hope this was useful to you.

Have a great week,

Sam Evans


DISCLAIMER 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.