Strong words and a dramatic title, but hear me out and I will explain.
It is not that indicators are without use; the problem is really that the way in which almost everyone uses them makes them useless. The important question is not exactly which indicator you use; but what that indicator is measuring, why you are using the indicator, and how it fits in as part of your complete trading strategy.
In my experience, indicators tend to hold new traders back from learning how to become good traders and help people blow their accounts. Still, almost every good trader I ever heard of (or read about) talks of a day when they realized that indicators were a waste of time as the day that everything began to change for them, so maybe indicators do serve a good purpose after all!
So, to fully explain why I hate indicators, I’ll start from first principles: what works in Forex, what doesn’t work, and where indicators fit in.
Real Trading Edges
A trading “edge” is a principle or theory that can be applied to determine whether the price of something is more likely to go up or down. Without this, trading is essentially gambling, with a negative edge due to broker commissions and/or spreads, slippage etc. This means that if you don’t have some type of “edge” with which to “beat the market”, you can expect to lose money, and if you continue for long enough, to lose all your money.
So, are there any positive “edges” that have been seriously tested and considered by many experts, academics, etc. to be tools that can be used to generate a positive expectancy of profit? The good news is that yes, there are a few, which can be divided into four broad categories.
Trend Following/Momentum: if the price is higher or lower than it was some time ago, it is more likely than not to continue in the direction in which it has been going.
Mean Reversion: if the price has deviated significantly from an average, it is more likely than not to revert to its average.
Time of Day: certain currencies, commodities etc. tend to be more volatile at certain hours, which usually coincide with the opening and closing business hours of major financial centers.
News Releases/Events: whether scheduled or unscheduled, economic data, political events, and central bank policy changes may trigger large and prolonged directional price movements in currency pairs.
Fundamental Analysis: prevailing fundamental economic conditions may drive trends.
So, having listed the possible “edges” that can be used to make a profit trading Forex, now it is time to ask whether there are any indicators that can help us in identifying and exploiting those edges. The answer is a very qualified yes. Time of day can be found on a simple world clock. News releases and events can be found by watching news feeds and checking an economic calendar. Fundamental analysis can be derived from macroeconomic data. None of these areas require the use of any standard indicators that you can find installed on your trading platform, although some platforms do have news plug-ins which can be helpful.
There are two areas remaining where indicators can help you: determining a price trend and determining an average price. Traders discover, correctly, that markets provide an edge from their tendency to move in oversized trends over a long-term horizon, and to revert to the mean (average) over a short-term horizon. This means that it is possible to use indicators such as moving averages, RSI and stochastics to help you with identifying and exploiting these edges. The problem is that the indicators don’t tell you how to calibrate them – what settings should you use? How much time should they cover to give helpful readings? There are good answers which can be shown to have worked in the past, but there is no “magic bullet”. Even worse, the good answers cannot be discovered from the indicators, because back testing with indicators is an over-optimized method which produces false positives. Too many traders make the mistake of back testing an indicator on one time frame and using the setting that gave the most optimal results in the past. This is known as “curve fitting” and can be very dangerous. A much better approach is to find a robust concept that works on all time periods, or at least over a wide range of time periods of a similar type.
Rely on Your Own Intelligence
One of the best discoveries you can make in the Forex market is this: the most robust predictor of trend is just checking the chart to see whether the price is below or above its price from X months. Trading this way, being prepared to let winners run and cut losers short, is more profitable than using any standard indicator to determine trend! Over the past 15 years, on major pairs, using look-back periods from 1 months to 12 months has produced positive results, simply buying and holding. That is what I call a robust edge, and you will not find it in an indicator (the RSI indicator comes the closest of them all).
The flip side is that on the shorter time frames, for example daily and below, the price tends to revert to its average. Great, you might think, I will trade a Bollinger band on the hourly chart. The problem here is that this will not be enough to give you a statistically positive edge, as profit targets are small. The only chance you have trading in this style is to look at long-term charts covering a month or more of action and trade those pairs which are congested, consolidating, ranging, going nowhere.
Finally, relying on indicators to do too much prevents you from using your own trading intelligence, your own feel for the charts that you will develop over many hours of screen time. More experienced traders can notice negative gut feelings about situations which an indicator may say are promising, with the gut feelings tending to turn out more correct. The human brain is far more powerful than any mathematical formula.
Use indicators only as a tool within a wider, intelligent framework.