The greatest debate on the trading platform comes in the form of indicators. Misunderstood and misused by many, they are dismissed as irrelevant or heralded as the ultimate solution to trading success. This article will explore the truth about indicators, their real value, and how professional traders can use them well.
Misconceptions About Indicators
Indicators always polarize people’s opinions. Some say that they are pointless, arguing they lag behind the price action. Others believe them to be some kind of magical tools that make any strategy work like a formula for winning. Both views fail.
Lagging Argument
Critics argue that indicators are worthless because they lag. However, all trading tools are lagging—including price action. The truth lies in the probabilities, the risk-reward ratio, and the expected value, none of which guarantee success.
Magic Tool Argument
Believers in a perfect indicator assume it can solve all trading challenges. This is a flawed approach. Indicators are not strategies; they are tools that enhance a trader’s ability to quantify and refine strategies.
What Are Indicators?
To understand indicators, it’s crucial to know their purpose:
Indicators Are Add-Ons
Indicators, like features of machine learning models, are just add-ons for improving strategy performance. They can be thought of like four-wheel drive or anti-lock brakes on a car—helpful but not a complete system on their own.
Indicators Are Statistics
Indicators are tools in statistics. They are derived from basic principles such as the mean, median, standard deviation, and derivatives. This helps traders to express specific market dynamics.
Using Indicators Wisely
Understanding and applying indicators begin with a proper understanding of what they measure.
1. Know What They Measure
Every trader using an indicator has to understand the foundation. Some such indicators are the moving averages, Bollinger Bands, or ATRs (Average True Range), and they measure the specific aspects of market behavior.
2. Know Your Purpose
Start with a trading strategy and identify variables you want to measure. For example, if you notice a pattern of increased volume during certain trades, explore volume-related indicators to test their impact on your strategy.
3. Test and Refine
After identifying an indicator, backtest it within the context of your strategy. Determine if it improves expected value, win rate, or risk-reward ratios.
Case Study: Using ATRs to Improve a Strategy
Now consider a strategy that is focused on intraday long trades on large gap-down stocks. Initial tests proved mediocre, but by analyzing ATRs from a long-term moving average, the trader is able to identify thresholds where the performance improves.
For instance:
- Trades with more than a certain number of ATRs from the moving average yield better win rates and profitability.
- Risk was scaled according to ATR levels, further enhancing the performance of the strategy.
This is the reason for quantifying relevant market dynamics instead of applying indicators blindly.
Takeaways for Traders
- Indicators are tools, not solutions. They enhance strategies but don’t replace sound trading principles.
- Focus on quantification. Use indicators to measure specific variables relevant to your strategy.
- Test rigorously. Backtest indicators in various market environments to validate their effectiveness.
A Professional Trader’s Perspective
Traders, at proprietary trading firms such as SMB Capital, treat indicators as statistical tools in refining strategies. They realize that most of them will not work for a strategy, but one right indicator makes a huge difference.
For instance:
- Volume profiles indicate distributions.
- Moving averages provide trend benchmarks.
- Bollinger Bands measure standard deviations to estimate the price extremes.
Professional traders do not rely on one indicator but use a combination of tools that are designed to fit their specific strategies.
Indicators: Controversial but Indispensable
Indicators are usually controversial because they force the trader to think and question his or her strategy. They are not a silver bullet, but they are irreplaceable for those who will learn and apply them correctly.
Whether you’re skeptical or a believer, one truth remains: understanding indicators and their role in quantifying market behavior is essential for any trader aiming for long-term success.
Let us know your thoughts on indicators—are they essential tools, overhyped, or something else entirely? Share your experience and feedback!