How to Choose the Right Indicator - Full Guide!

28 dic 2020

Many traders, especially when starting out find themselves in a constant search of the best trading strategy.
A quick Google search is enough to scare anyone starting out, as the number of indicators and strategies to use under different market conditions is overwhelming.

In this article, we will discuss *1* indicators nature and the correct way to use it,*2* how to choose the right indicator, and most importantly *3* how to know if the indicator is reliable or not.

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First, what are indicators? Origin and Nature

Indicators are statistical tools that digest price data, OHLC of each candle, add a formula to it, and then convert it into visual information such as graphs or oscillators. Indicators provide information about the strength of a trend, momentum, and possible reversals.
When it comes to indicators, we can divide them into four classes: Momentum indicators, Trend indicators, Volatility indicators, Volume Indicators.
Knowing which one belongs to which category can help you make much better trading decisions. On the other hand, combining indicators in a wrong way can lead to a lot of confusion, wrong price interpretation, and, subsequently, to wrong trading decisions.

The correct way to use indicators. Indicators don’t provide signals.

Most traders never look at the indicators they are using and even less have ever tried to understand the formula the indicator uses to analyze price. They then use their indicators in the wrong context and wonder why nothing works.
Indicators don’t tell you when to buy or when to sell. They don’t even tell you when something is overbought or oversold.
Indicators are great tools if a trader understands their true purpose. Indicators provide information about price, how the price has moved, how candles have shaped, and how recent price action compares to historical price action. Again, not a direct signal to buy or sell.

Thus, the job of a trader is to interpret the information on their indicators in a meaningful way and turn it into a story about price action and buying/selling pressure. Who is in control right now? Is the market ranging or trending? Is price losing strength or gaining momentum?


How to choose the right indicator? That suits your trading style and personality

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* Meaningful: Represents important information.
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Your indicator choice should match your trading style. The purpose of indicators/strategies is to offer a way to identify clues and to provide a framework for traders to work in. Our main job, as traders, is to collect clues and combine them in a meaningful way to have an edge over the market.

Only add indicators that help you put the odds in your favor. -- If it doesn’t, you don’t need it.

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* Objective: Has a clear operational definition of what is being measured.
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Indicators are ideal for rule-based trading as indicators take out the guesswork by providing information that is totally objective especially for newbies who are struggling with discipline.

The most successful strategies/indicators are those where not a lot of individual interpretation is required.

Only use indicators that help you make objective decisions. -- If it doesn’t, you don’t need it.

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* Understandable: Easy to comprehend and interpret.
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Indicators are great tools especially for amateurs who do not know how to relate price data into meaningful relationships.

Indicators' main purpose is to make your life easier, not more sophisticated.

Remember: K.I.S.S. Keep it simple stupid! -- If it is complicated, you don’t need it.


Last but not least, more is not always better:
The problem with indicator redundancy is that when a trader picks multiple indicators that show the same information, he/she ends up giving too much weight to the information provided by the indicators.

“All Strategies / Indicators are good; if managed properly.”
~ Rich

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How to know if the indicator is reliable? Cheat Sheet Checklist

* Does it repaint, disappear or recalculate?
We have all been there. An indicator looking good /profitable on the chart, but perform horribly under live market conditions. Most indicators are designed to only show/keep winning signals. Do not, ever, include an indicator in your trading plan before testing it on a demo account.

Here is a simple step by step guide on how to test indicators:
- Attach your indicator to any chart.
- Keep your trading platform running for a while for the indicator to plot a couple of signals.
- Take a screenshot of the chart.
- Refresh by switching between the timeframes.
- Compare your chart with the screenshot

If the indicator’s signals /drawings change location or disappear, then it is a red flag. Such indicators are not reliable and shouldn’t be used in any way.


* Does it lag?
In general, indicators are lagging, but so is price action. An indicator can only analyze what has happened already. Just as a candlestick or chart pattern only includes past price data.
Nothing to worry about so far, as we mentioned above, indicators only provide information and do not offer signals.
However, some indicators are too lagging. This kind of indicators looks good on historical data but appear too late under live market conditions.
Pro Tip: Always take into consideration when, where, and how does the signal appear.


* Is it TradingView friendly?
90% of custom indicators do not work on TradingView, because PineScript does not allow recalculation. Thus, the signal/drawing can’t be modified once it is generated by the indicator.
Therefore, indicators that are available on TradingView stand out from the crowd, and they are considered more reliable.

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In brief, indicators are very famous tools and used by millions of traders. However, often traders don’t really know what their indicators are doing or how to use them.

Always be aware of the objectives of your trading style and what you are trying to accomplish with the indicators. Then, adjust accordingly. Once a trader can stop using indicators as signal-tools, he will be able to transform his trading to new heights. Happy trading!