By Michael Kahn
As I often say about my wine savvy, I know just
enough to be dangerous. For many traders, the same holds true with
regard to charting and technical analysis.
They know enough to
use an RSI (relative strength index) to gauge momentum but really don’t
know why they use a parameter of 14. And they use the same process day
in and day out because they heard it once in a webinar or read it once
in a book.
Trading teachers will tell us to find something that
works and stick with it. I contend that unless you understand the “why”
and not just the “what” you are setting yourself up for trouble down the
road. After all, markets evolve and what worked yesterday may not work
today.
This missive is not about deconstructing technical
indicators. Rather, it is to get the reader to think about the spirit of
the analysis and letting the charts speak to them. Any other method
implies that traders are making the market conform to their own biases.
The market hates that and it will make you pay dearly for trying.
Let’s
start with RSI and the 14-parameter. Why do so many traders use it? The
answer is that is the default setting on the first applications of
charting software that came out a few decades ago. There was reason
behind it as Welles Wilder, the creator of RSI, was using half cycles in
his favored markets as the basis. But once software coders and
inexperienced product marketing managers got something in their heads it
seemed to be set for life. Even today, many software programs do not
let the user change the default parameter to something different.
Of
course, indicator parameters should be in sync with the market and
time frame in which they are being used. But it goes beyond that.
Because markets evolve, indicators can behave differently than they did
when they were newly created. Today, “everyone” sees what they think
are overbought and oversold levels at the same time and act accordingly.
How many times in recent memory have signals simply failed just because
everyone – the herd – is taking the same action?
Rather than
over-think an indicator or even a chart pattern, here are some rules
that will make your life easier and more profitable. They are all rooted
in keeping it simple and more importantly letting the market do all the
thinking. All you have to do is turn off the news and absorb the
message.
Rule 1 - If you cannot see trends and patterns almost
instantly when you look at a chart then they are not there. The longer
you stare, the more your brain will try to apply order where there is
none.
If you have to justify exceptions, stray data points and
conflicting evidence then it is safe to say the market is not showing
you what you think it is.
Rule 2 – If you cannot figure out if
something is bullish or bearish after three indicators then move on. The
more studies you apply to any chart the more likely one of them will
say “something.” That something is probably not correct.
When I
look at a chart and cannot form an opinion after applying three or four
different types of indicators – volume, momentum, trend, even Fibonacci –
I must conclude that the market has not decided what it wants to do at
that time. Who am I to tell it what it thinks?
Rule 3 – You can torture a chart to say anything you want. Don’t do it.
This
is very similar to Rule 2 but it there is an important point to drive
home. You can cherry pick indicators to justify whatever biases you
bring to the table and that attempts to impose your will on the market.
You cannot tell the market what to do – ever.
Rule 4 – Be sure
you check out one time frame larger than the one in which you are
operating (a weekly chart for a swing trader, a monthly chart for a
position trader).
It is very easy to get caught up in your own world and miss the bigger picture getting ready to smack you.
It can mean the difference between buying the dip in a rising trend and selling a breakdown in a falling trend.
Rule
5 – Look at both bars (or candles) and close-only line charts to see if
they agree. And look at both linear and semi-logarithmic scaled charts
when price movements are large.
Short-term traders can ignore the
latter since prices are not usually moving 30% in a day. But position
traders must compare movements at different price levels.
As for
bars and lines, sometimes important highs and lows are set by intraday
or intra-week movements. And sometimes intraday or intra-week highs and
lows are anomalies that can safely be ignored. Why not look at both?
Rule
6 – Patterns must be in proportion to the trends they are attempting to
correct or reverse. I like the trend to be at least three times as long
as the pattern.
A three-day correction is not sufficient to get a
six-month trend back on track. And a three month pullback after a six
month rally is probably a new trend, not a correction.
Rule 7 –
Patterns should have symmetry. A triangle should look like a triangle
and not a mile high and an inch wide (or vice versa). A
head-and-shoulders should look like a central peak with two smaller but
equal peaks around it.
Rule 8 – Price rules but it is better when
volume, momentum and structure (patterns) agree. Sentiment is a luxury
because it is often difficult to quantify.
No matter how strong
the case built on indicators and the environment surrounding the market
may be, there is no change in condition until price action reflects it.
How many times has an overbought market become even more overbought?
Rule
9 – Always confirm one type of analysis with another type. For example,
confirm RSI not with MACD but with on-balance volume or relative
performance.
There are hundreds of indicators but only a handful
of truly unique types. Be sure you do not try to prove your case with a
variation on the same set of input data. Most momentum indicators are
quite similar so be sure to look at at least the three types listed in
Rule 8.
Rule 10 – Don’t get hung up if all your indicators do not
agree. They never will all agree and you will end up missing every
opportunity. Therefore, pretend you are a trial lawyer gathering a
preponderance of evidence, not guilt beyond a shadow of a doubt.
Rule
11 – If a stop is hit you must honor it. All big losses start out as
small ones. No exceptions. Feel free to re-analyze a trade that got
stopped out to see if you would enter anew but never justify holding on
to a loser.
Again, nothing here is rocket science but these rules
force you to let the market talk. After all, that is our job as
traders, reading the signs and acting accordingly.
http://www.tradingmarkets.com/
I have read the rules and all the rules are worth to read.Well nothing here is rocket science but these rules force you to let the market talk for Forex signals
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