More often than not when a trader uses an indicator that is widely promoted, they are unknowingly setting themselves up for whipsaw trades and chronic mediocre trading profits. Here are 7 tips for selecting the best Indicators for trading the automated marketplace:
1. What is the Market Condition? This is not the uptrend or downtrend, but the overall condition of the market which is derived from the Market Participant Cycle. There are 9 distinct Market Participant Groups. Where, when, and how they buy or sell dictates which of the 6 Market Conditions is present at any given time. Usually a Market Condition will dominate for several weeks to several months or longer. The Market Condition above all else dictates what indicators will work ideally at that time.
2. What was the indicator writer's intent? This is critical to know because each indicator writer developed their indicator based on a specific Market Condition that was present at that time. They saw price and volume behaving a certain way, and wrote an indicator to expose that pattern and what it meant for trading or investing.
3. What are the limitations of the indicator? Every indicator has strengths and weaknesses. As an example, it has been proven empirically that MACD only works during a momentum uptrend. It fails dismally for selling short trading, and creates whipsaw trades during trading range and platform market conditions. Knowing the limitations helps traders avoid using that indicator in the wrong Market Conditions.
4. What Market Data is present and used in the formula? Traders do not need to be mathematicians or learn how to write indicators, but they do need to know what data is included in the indicator. Price and Time indicators tend to lag as price must first move before the indicator can display the pattern in a line or histogram. Volume and time indicators in our automated marketplace tend to lead to some extent due to how large lots buy and sell nowadays. Volume, Price, and Time indicators which are the new Hybrid Indicators lead price as they incorporate all of the market data in their formulas.
5. How old is the indicator or when was it written? Indicators written 50 years ago were written for an entirely different Market Structure. On balance Volume and Stochastic were written during a time when there were no retail traders, online brokers, or internet. There were no pension funds allowed to invest in the stock market. There were far fewer institutions, and the average person only invested for the long term. Therefore these older indicators are not designed for the automated marketplace, and are not appropriate for many modern trading styles and strategies.
6. Do High Frequency Traders use the indicator in their HFT algorithm strategies? This is a huge factor many individual traders never consider. HFTs use the overly popular indicators such as MACD, Stochastic, or Moving Averages in their algorithms to find cluster orders that they can exploit on the millisecond time scale. Since individual traders are not allowed by law to trade on the millisecond scale and since their trading platforms do not show the millisecond tick or price, using these indicators is significantly higher risk. Cluster orders are anomalies that form when many individual traders are all using the same indicator, trading strategy, trading system or other popular entries. Cluster orders are easily recognized by the HFT algorithm, and used to trade against the mass of traders all trading the same way.
7. Does the indicator expose where the giant lot institutions are quietly accumulating? With the largest institutions now using Dark Pool venues for their transactions, it is imperative that retail traders use indicators that reveal where the giant institutions are quietly moving in or out of a stock. Specific indicators written in the past few years can identify these important market participants.
Choosing indicators should not be about using what is most popular, what your online broker recommends, or what your charting software promotes but what is best for your trading style and strategies. If you use an overly exploited or very popular indicator, be aware that High Frequency Traders HFTs are now employing algorithms that quickly identify large groups of individual traders all trading with these indicators. Learning the new hybrid indicators written for the automated market and the new market structure, will lower your risk and increase your potential profits.
The Market Structure has changed more in the past decade than in the prior 100 years. Using outdated indicators leaves individual traders struggling with chronic whipsaws, weak stock picks, and disappointing results. If you spend time learning to use new indicators, it will be worth it.