NOVICE TRADER
Examining Your Toolkit Of Indicators
The Tools Of The Trade
by Martha Stokes
Here's an overview of the array of tools you need in order to trade successfully.Every professional knows that the right tools are essential to success. A carpenter wouldn't use a sledgehammer to nail an interior window frame, nor would he (or she) use a framing waffle-head hammer. He knows that the ideal hammer for fine finish work is a finishing hammer that has a smooth head and is lightweight. By using the right hammer for the job, the carpenter gets the results he wants.
YOUR TOOLKIT FOR TRADING
The same applies to trading. Whenever a trader comes to me struggling with less-than-satisfactory results, I first check his or her toolkit of indicators. Many factors can cause this trader to have disappointing results; often, the primary culprit is not understanding how to use indicators. The most common problem is that traders will use several indicators that are basically all tracking the same market data and are missing indicators critical for tracking the full range of data for the stock. The toolkit of indicators is out of balance. That trader is using a sledgehammer instead of a finish hammer.
You need to track all of the aspects of market data available. This includes the market condition, the trend pattern and the strength of that trend, the velocity of price action, large-lot buying or selling patterns, price strength against its own recent price action, the quality of that price action, the status of money flowing into or out of the market or stock, and most important, the quantity of shares being traded.
Sadly, what most traders have in their toolkit of indicators is only one or two of these aspects of market data. Fortunately, this is one of the easiest trading mistakes to correct. Let's start by reviewing some of the basics of indicators.
FRAMING HAMMER OR FINISH HAMMER?
Indicators are just what the name implies. Indicators are the primary tool a technical analyst uses to determine an "indication" of market or price direction, velocity, and potential strength of such action. Indicators are not hard rules or precise facts but do imply what price is likely to do. Investors and traders must use an indicator for what it was designed to do, such as indicate overbought or oversold conditions, or accumulation or distribution. It is also important to remember that certain indicators do not work well under certain market conditions and that specific indicators were designed specifically for short-term evaluation rather than long term. Most critically, indicator settings need to be adjusted for market conditions, trading styles, and trading strategies. As the market shifts and changes, you will need to modify your indicator settings and the types of indicators you use.
Market conditions, not strategies, define which indicators are best for that particular market. Do not make the mistake of trying to use a strategy and its indicators in the wrong market conditions. Many traders get so caught up with the latest hot new strategy that they forget the basics of first analyzing the current market condition and then applying the appropriate tools and strategies.
Market condition is an indicator unto itself. This defines how you can trade the market at a particular time. Market condition tells you whether to use a "framing hammer" indicator or a "finishing hammer":
Market conditions:
1. Trending up or trending down
2. Wide sideways trading range
3. Consolidating in a tight horizontal price action
4. Insipid (dull market)
5. Momentum markets, the favorite market condition for daytrading and swing trading.
...Continued in the October issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the October 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2006, Technical Analysis, Inc.
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