Systems and Technical Analysis Indicators
by Archie Johnson
Many new traders have a tendency to confuse
trading systems and technical analysis indicators. From
my observations, the majority of the confusion comes in
the form of confusing the use of technical analysis indicators
with systems. Nevertheless, I'll discuss both here.
An technical analysis indicator is used to determine
the trend of a market, the strength of the market and
the direction of the market. A technical analysis indicator
may be specific or non-specific. Some technical analysis
indicators can be quantified in the form of an equation
or algorithm. Others show up as patterns (e.g. head and
shoulders, trendlines, support and resistance).
At some point, the technical analyst will receive a signal.
This signal is the result of one technical analysis indicator
or more than one technical analysis indicators in combination.
The signal indicates to the technical analyst a course of
action (e.g. buy, sell, hold). The technical analyst will
determine the method to use. However, it must be specific,
objective, and reliable. The method is a subjective and
not mechanical. This is a significant difference between
a trading system and a technical analysis indicator.
Anyone with an imagination can create a technical analysis
indicator. Everyday at least one new technical analysis
indicator is created. Over the years thousands have come
and gone. Most of them don't tell us anything about a
market that time tested technical analysis indicators
tell us. They're useless. Many others are of no use whatsoever.
Timing indicators tend to work in some types of markets
(e.g. trending or sideways) and not others. They may also
work with some securities and not others. Therefore, they
tend to be unreliable. Timing indicators are also subjective
and require interpretation. Based on my experience, most
amateur traders tend to use timing indicators and base
their decisions to buy, sell, or hold on them. Many traders,
after using an indicator or indicators with success turn
them into a trading system. This does not mean that the
trader has found the holy grail of trading systems. Instead,
what many traders find is that when the indicators are
combined into a trading system, they lose their effectiveness.
Technical Analysis Trading
A trading system is created by generating signals, setting
up a decision making procedure, and incorporating risk
management into the system. A trading system is supposed
to be objective and mechanical. The analyst combines a
set of objective trading rules (usually in a formula(s)
As a general rule, good technical analysis indicators are
the building blocks of good trading systems. However, as
previously mentioned, even good technical analysis indicators
can lose their validity when combined in a trading system.
Therefore, it is important to not only back-test your system
but to also forward-test your system in real time.
Pitfalls of Trading
Systems and Technical Analysis Indicators
Trading systems are supposed to be objective and mechanical.
They take the intuition out of trading. Buy when the system
tells you to and sell when the system tells you to. The
problem is that there are not a lot of good trading systems
Traders tend to lose objectivity when using technical
analysis indicators. The trader is not able to remain
objective and the subjectivity of using the indicator
overwhelms him. I think it has to do with a compulsion
many traders feel to have to trade. They then tend to
subvert their indicators by trading when the signal is
not entirely clear.
Traders have a tendency to test their trading systems
and technical analysis indicators on an insufficient amount
of data. Analysts need to test trading systems and technical
analysis indicators on a wide array of data in different
types of trading markets. Additionally, many traders and
analysts don't forward test their trading systems and
technical analysis indicators in real time. They rush
to trade based on insufficient back-testing and forward-testing.
Thus, it is really hope that they are trading on and not
a sound, valid basis.
Many traders fail to incorporate sound risk management
techniques in their trading systems. Additionally, many
traders fail to incorporate stop loss orders with their
initial orders when using technical analysis indicators
Traders also tend to over-optimize their trading systems.
They start asking the what-if question and back-test the
trading system with different parameters. Of course they
are going to trade with the parameters which generate
the highest amount of wins. However, in real time these
over-optimized systems rarely perform well.
Another trap traders fall into is to use too many technical
analysis indicators. Find the few that work consistently
well for you and go with them. I find the time tested
technical analysis indicators to be the best. However,
there is no reason you won't find some new indicator that
works consistently well for you. Just make sure that you
forward-test it in real time.
I have always considered speculative trading more of
an art than a science. The best traders I've ever seen
use technical analysis and intuition. However, despite
their intuition, one thing common to all of them is that
whether they can articulate them or not, they all have
a set of well defined rules they trade by. They consistently
generate very nice profits.
If you are considering buying technical analysis software
be very skeptical of systems that advertise tremendous
results. They have probably been over-optimized to show
excellent back-tested results and won't work when you
try to use them. Of course the company will have a whole
list of reasons why it isn't working well at that particular
point in time. However, excuses don't do you any good
when you're losing hard earned money. Draw downs are money
out of your pocket. You will never make it back.
Last, what works for one trader may not work for another
trader. If it works for you - that's all that counts.
Article by Archie Johnson
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