Are technical indicators worth using? Which ones should I use? Is there one indicator that is better than another? MACD? Stochastics? RSI? Stop the madness! The only thing you need is an understanding of price action.
If you are new to trading stocks you will do yourself a great disservice by trying to use technical indicators to trade stocks. You are far better off by first learning to trade stocks based on price action alone. So put away your OBV, CCI, and PPO for now and just focus on the chart.
Leading And lagging indicators
Technical indicators are generally classified into two categories: Leading Indicators and Lagging Indicators. Leading indicators like stochastics are supposed to lead the price action. Lagging indicators like moving averages follow price action.
This is what they are supposed to do but in reality all technical indicators are lagging indicators because they cannot draw on a chart until after the price action has already been established.
Remember that all technical indicators are generated by using the high, low, open, close, or volume of a stock. It gets this information from the price action in the stock first, then it shows up on your chart as RSI, MACD, etc. Therefore, these indicators can never tell you anything more than what the chart is already saying!
Learn how to interpret price first
Ok, now that you know the truth about technical indicators, you can finally relax. You can stop looking for the perfect indicators to solve all your trading problems. So what should you look for on a chart? Good question! The main thing that you are trying to figure out on a chart is the psychology of other traders.
You are trying to figure out where they are going to buy and where they are going to sell. You are trying to get into their heads! You want to know if they are excited, nervous, scared, or uninterested.
Every stock, in every time frame, alternates between these four emotional extremes. A stock breaks out of a consolidation (excited), momentum slows down (nervous), traders begin to sell (scared), the selling finishes and there is indecision (uninterested). This cycle repeats over and over again.
As a trader you look at price to find the point at which one emotional state is about to evolve into another. Candlestick patterns are useful to determine these turning points. They will give you these signals far in advance of any technical indicator!
Using technical indicators the right way
You still want to use indicators in your trading? That’s fine, just use them the right way – to indicate! If you like using RSI then use it to tell you that a turning point may be coming. Then just forget about it and focus solely on the price action in the stock.
Too often I see traders buying stocks just because an indicator is overbought or oversold. A stock can become overbought or oversold for a very long time. In the meantime you have a position in the stock and you are losing money!
Look for divergences. If there is one thing that technical indicators can be useful for is the ability to identify those times when price is at odds with the indicator. This can signal that a turning point may be coming. As always look at the candles (price) for validation.
Use the right indicator for the job. For analyzing trends using trend following indicators like moving averages. For trading ranges, use oscillators like RSI.
Remember that you do not need any kind of indicator to trade stocks and you certainly should not be using them until you have a full understanding of how to interpret the price action. Even then you may opt to never use them in your trading. I don’t use any on my charts.
It has been said that “technical indicators are for novice traders who do not know how to interpret price”.
I would have to agree with that.