Investors and traders who analyse stock market indices and individual stocks or commodities, use various indicators. These indicators produce signals and patterns which the traders and investors use in order to make sense of price action in the markets, and determine the underlying trend. The trend itself is always a function of the time frame, time frames vary from seconds to months, so the actual trend may be up or down depending on the time frame in question. Traders themselves decide what time frame to focus on, and what their objectives are. The market itself provides the risk and the opportunity through confusing, often volatile trading.
Indicators used in stock market investing and trading, range from simple moving averages, oscillators and chart patterns, to more complicated indicators which take into account more variables, such as trading volume. All indicators and analysis techniques give false trading signals every once in a while and they all can give conflicting signals from one time frame to another. So analysing the markets is a very difficult task, one that tends to discourage new traders from pursuing the idea of trading. Also, the shorter the time frame of interest is, the more volatility the trader encounters, and the more the false signals that they will come across. Investing on the other hand is a more relaxed, less stressful approach to the markets, especially for new traders, since it is identical to trading but the time frame is much longer. As a result, investors act much like traders but they have much more time to make trading decisions, and avoid false signals. The problem with investing as opposed to shorter time frame trading is that significantly more funds are required, as well as much more patience.
In order for investors or traders to succeed in the financial markets, they have to treat this entire endeavour as a serious professional, yet risky mission where the outcome cannot be guaranteed. Risk is always present in the financial markets, and no one can overcome it completely. The market is always a step ahead, and even sophisticated self-learning software utilizing advanced pattern recognition algorithms cannot beat the market. That’s why all commercial products and trading tools that claim to beat the market actually fail sooner or later. Because the market is so much more complicated than these software products can ever deal with.
Indicators are the best alternative to predicting the financial markets, most don’t work even fifty percent of the time, and yet when used wisely, and with patience they can still allow traders using them to make money in the markets. There is nothing wrong with using popular indicators, as long as one does not use popular methods of interpretation for understanding the readings on these indicators. It is popular interpretation methods that simply never work reliably, not the indicators themselves.
The SP500 index with its 50 day moving average overlaid, and the MACD oscillator (below).
MACD Indicator
Moving averages are used by many traders as a way to establish a simple level of support and resistance in the markets, that level is usually good for a short period of time only. Another popular indicator which is based on moving averages is the moving average convergence divergence indicator or MACD. The MACD indicator is on of the earliest oscillator-type indicators, it is unreliable for the most part since it tends to produce many false signals, but occasionally it does produce some leading signals because moving averages themselves can act this way every once in a while. The blue bars in the middle of the MACD oscillator form its histogram, this helps eliminate false signals when it begins to disagree with the MACD lines. The MACD lines, as depicted on the above chart in black and red, simply produce crossovers. The two lines are of different time frames and traders regard them as being bullish when the short period line crosses over the long period line and vice versa. The histogram seen in blue bars in the middle, can serve as a rough gauge for eliminating false signals, simply by looking at its behaviour. If the MACD lines are suggesting the market is going higher, but the histogram starts to make new lows, then this is a warning that the market in question will stop rising soon, it may go down or move sideways for a while.
There many more indicators used by traders, but also there are actual chart patterns, such as highs and lows, specific patterns that suggest the market will go in one direction rather than the other and so on. The important thing to remember here is that the chart itself, with its price formations alone is always more important than any moving average or any indicator. When the chart of the market itself produces compelling patterns, using price alone, and they seem to be in conflict with indicators such as MACD or any other indicator, then in such cases the chart formations prevail. And in such cases traders ignore the off chart indicators, and even the moving averages. This is because price and price formations are more important and more closely watched by institutional traders than any other indicator. Indicators are still important however, since quite often there might be no price formations or there might be only large price formations, which can only predict long term trends but not the next few days. So indicators can come to the rescue and traders can even change their settings to make them more or less sensitive for the time frame in question.
