Limitations of Technical Indicators

Terry Allen

My last article advised that technical indicators could be use as essential components to your Forex trading System by helping you detect the entry and exit points of all your trades. Two more are discussed here explaining their benefits and limitations:

1. RSI High-Low
No trading system can depend on the RSI indicator solely on its own. However, the use of the RSI, in conjunction with other Statistical tools and proper technical analysis, can provide you with an extra edge to your trading.

Setup:
Currency pair: Any. Time frame: Any. Indicator: RSI (14, 70, 30)

Entry rules: Buy when the RSI crosses below its 30 line, forms a bottom, and then crosses back up through 30. Sell when RSI has crosses above 70, forms a peak, and then crosses back down through 70.

Exit rules: Ideally, when the next opposite BUY/SELL condition is
encountered as just defined.

RSI is a very good indicator for identifying Entry and Exit points for both simple and complex trading systems. However, careful monitoring is needed because false signals can occur. There are additional problems to consider such as:

The market will not realize that it may be above 70 or below 30. As a result, further large movements can still happen after these conditions are met without the anticipated reversals occurring. Although these movements may only cause just a few points rise in the RSI value e.g. 71 to 76, the market could surge by another 200 pips or more. If you had set a new SHORT at RSI 71, a violent BULL action could quickly STOP OUT your new trade.

2. Stochastic lines crossover
The Stochastic technical indicator is very effective at determining Entry and Exit points if the Market is following a structured statistical pattern.

Setup:
Currency pair: Any Time frame: Any Indicator: Stochastic (14, 3, 3)

Entry rules: Enter a new trade when the faster-moving Stochastic crosses above or below the slower-moving one.

Exit rules: Exit the trade when the opposite crossovers occur.
The Stochastic provides well defined entry and exit points and
is easy to use. However, the Stochastic is a lagging indicator and, as such, it can create false signals. Traders may need to monitor and even change the indicator’s settings constantly in order to adapt to the ever-evolving Market conditions with the intent of minimizing the number of false signals. Again, there are more problems to consider:

1. In a similar way to the RSI, the Market could surge in the opposite direction of a crossover. This is more of a problem than with the RSI because the Stochastic lags real-time.

2. If the total time between the entry and exit crossovers is quite long, this will leave the trade vulnerable to large spikes in price movement. The Stochastic would respond very slowly to such events and, as a consequence, would fail to advise you quickly enough that you need to consider corrective action promptly.

This article is part of a course intended to show you how to design your own successful Forex Trading System.
 

Terry Allen

Terry Allen is a career Forex trader who has written hundreds of articles for DailyForex and other industry websites. He is the co-author of an Amazon e-book titled Kick-Start Your Forex Career, which outlines the information that everyone needs to know before starting to trade Forex. Terry has been featured on Benzinga and Seeking Alpha.

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