At this point in your trading career, you are probably aware that 90% of Forex traders lose money on a consistent basis. What you may not be aware of is the correlation that exists that could potentially explain this high failure rate.
We all know that Forex traders love technical indicators. They love to experiment with different combinations just as much as they love finding new ones to tinker with.
There is a certain flood of excitement for most traders when they discover a new indicator or combination of indicators. It’s that “aha, this is the one!” moment that keeps most traders in the game searching for the lost treasure.
I would argue that 95% of traders use indicators in some way, shape or form. And not just a single indicator here and there. I’m talking about three or more indicators that are used in conjunction as buy or sell signals.
Is it a coincidence then that 90% of Forex traders lose money consistently and 95% of Forex traders use a plethora of indicators?
Perhaps, but knowing the success rate of traders who move from an indicator-based strategy to that of raw price action, I have to argue that it is not coincidental.
But this isn’t just a rant from some Forex trader who is opposed to indicators. It’s a detailed look at why those indicators on your chart may be doing you more harm than good. All of this from a trader who has experienced the highest highs and the lowest lows that the Forex market has to offer.
So, if you’re ready to face the harsh truth about indicators, I invite you to read on.
Have you ever noticed that the best things in life are often the simplest? A coffee machine, for example, is a brilliant necessity (in my opinion) yet it’s incredibly simple. This is, of course, coming from a guy who loves his coffee.
The charts you trade from should be viewed in a similar manner. You don’t need 8 indicators combined with multi-time frame analysis to make consistent profits.
Simple price action is all you need to get the job done.
That said, all indicators are not “bad”. I personally use the 10 and 20 EMAs, however, they don’t take up much real estate, which allows me to clearly see my charts at all times.
I also don’t use them as an entry signal, but rather as a way to compliment the price action strategies I trade with.
But this wasn’t always the case. Before finding price action, I used a ton of different indicators. In fact, I can recall having as many as 7 indicators on my chart at one time. How I even saw what I was doing, I have no idea.
My charts were cluttered in a bad way. More importantly, my trading was sloppy because of it.
Not being able to see what I was actually buying or selling left me guessing 9 times out of 10. Each time I was hoping that I had found the magic combination of indicators, and each time I was disappointed with the results.
But there was an inherent flaw in what I was doing. To illustrate what that flaw was, let me ask you a question…
If you are placing a sell order on EURUSD, are you selling an indicator or a currency pair?
I know what you are thinking – that’s a silly question! And I agree.
Of course, you aren’t selling an indicator. It isn’t possible, nor would it make you a profit even if you could do it. Yet it’s what Forex traders do every day. They see their indicators cross over in a way that triggers a buy or sell signal and they pull the trigger.
Who knows if that short position is about to hit key support, or if the pair is in the process of forming a bullish continuation pattern. The indicators said sell, so they sold – even if they aren’t quite sure what they sold or why they sold it.
Focus is important for a trader. It allows for clear thinking and prudent decision making.
But what if you’ve been focusing on the wrong thing?
This is a very real possibility if you have been putting all of your time and effort into finding the perfect combination of technical indicators. By doing this, you have effectively taken yourself out of the game.
Think of it like this. When you drive a car, do you simply stare at the lines on the road or do you focus on the road ahead?
I hope you do the latter, especially if you live near me.
Focusing on nothing but indicator crossovers and “overbought” or “oversold” signals is the same as staring at the lines on a road while driving. It won’t provide clarity on where you’re going nor will it help you make informed decisions about what to do next.
And regardless of whether you’re driving or trading, they both end the same way – with a crash.
If you have been working tirelessly to find that perfect combination of indicators, as most Forex traders do, you have been misdirecting your focus. After all, indicators only show second-hand data and will never make you a penny by themselves.
It takes price movement to make money. Without it, technical indicators would not exist.
How many technical indicators exist in the world of Forex? Is it a 1,000 or closer to 10,000?
The truth is, it’s infinite.
While there are a few dozen of the more popular indicators such as the Moving Average Convergence Divergence (MACD), Stochastic Oscillator and the Relative Strength Index (RSI), there are thousands of other lesser-known indicators available for use.
There are also what I call “Frankenstein” indicators that are being hatched out of traders’ basements every single day. Combine that with the endless customization that can be applied to any one of these indicators and you have an infinite number of combinations and permutations.
What is a permutation, you ask?
If a combination is a collection of objects, a permutation is a set of objects in a specific order.
To put that in trading terms, you may use a combination of a MACD, Stochastic, and two moving averages. However, in order for your strategy to trigger a buy or sell signal, you need a moving average crossover followed by a MACD crossover followed by a Stochastic crossover. That specific order becomes the permutation of the combination.
Why does all of this matter?
For the answer, we have to go back to the basics of why technical analysis works.
We know that market psychology plays a major role in determining how price action unfolds. Part of that human behavior is controlled by something called “herd mentality”. In the case of Forex trading, it describes how traders are influenced by the market as a whole in their decision-making process.
An example would be a key resistance level during a strong uptrend. If the bulls manage to break through the level, odds are that demand will be strong in the event the level is tested as new support.
Why is that the case?
Put simply, everyone is using the same information to make their trading decisions. Although it’s been heavily debated, you could, therefore, call technical analysis a self-fulfilling prophecy in that the very nature of its effectiveness is predicated on the fact that many traders use it to forecast future movement.
Of course, we know that retail trader sentiment is often used as a contrarian indicator, but the concept of herd mentality applies nonetheless.
To make the connection to our comparison between price action and indicators, we have to look at the numbers.
There is only one support level in the scenario I just gave, whereas there are thousands of different buy or sell signals being triggered by the infinite number of combinations and permutations of various indicators.
Sure, not everyone will have the same exact level on their chart. But if it’s truly an obvious area of value, the majority of traders will at least take it into consideration before making their next move.
One of the keys to becoming a successful Forex trader is to only take the obvious trade setups. These are the setups that form at obvious levels.
Unfortunately for most traders using indicator-based strategies, they aren’t able to capitalize on this concept. This is because there is nothing obvious about thousands of different entry signals being fired off from an infinite number of indicator combinations and permutations.
Therein lies the problem.
There is, however, something universally obvious about a key support level that took two years to form.
The only way to know if any trading strategy is worth its weight is to test it. The testing period required depends on the strategy, however, anything less than a few months’ worth of data is typically considered insufficient. And the daily time frame only exacerbates the issue due to the lesser frequency of quality trade setups.
This is why it can often take years for a trader to find a suitable style of trading.
But consider this…
There is only one head and shoulders pattern just as there is only one wedge and one bull/bear flag.
Yes, some are more lucrative than others and some may form on the daily chart while others form on the 4-hour chart and so on.
But the pattern itself is unique.
The proper way to trade these price structures is also unique. For example, there is only one way to trade a head and shoulders reversal, and that is to enter on a break of the neckline.
It doesn’t get much simpler than that. And this simplicity allows for a relatively short learning curve.
Now compare that to the infinite number of combinations and permutations that exist with technical indicators. The fact that there is such an expansive list of indicators to choose from combined with the infinite number of individual settings and combinations makes testing these strategies seem endless, and to some extent it is.
Some may argue that the solution is to either manually or automatically backtest these strategies for faster end results.
However, there is a reason why all investment vehicles at every major firm include the fine print, “past performance is not indicative of future results”.
You may spend days, weeks or even months backtesting a strategy over the last 5 years’ worth of data, but it’s anyone’s guess whether that strategy will continue to work for the next 5 years. And that’s what is important, not what happened in the past.
There is also the debate about the lack of human interaction when it comes to backtesting. We all know that emotions are the number one killer of trading profits. So, when you automate this backtesting, you are inevitably going to come up with incomplete results due to the missing human element.
At the end of the day, testing various trading strategies takes time. This is true for any strategy, regardless of whether it’s indicator-based or not.
That said, I would argue that price action is the lesser of two evils when it comes to the length of backtesting required.
While there are various ways to trade price action, each pattern or strategy comes with its own unique set of rules. This limits the number of ways in which it can be traded.
After all, there is really only one way to trade a head and shoulders pattern. Someone at some point may have come up with a variation, but situations such as this are far and few between and are certainly not conventional.
For comparison purposes, how many ways are there to trade a MACD once you factor in the different settings and other technical indicators it can be paired with?
…infinite would be a good guess, and that’s a lot of backtesting.
At this point you might be thinking – wait a minute, there are some profitable Forex traders who have developed their own indicator-based strategies.
And you’re absolutely right.
But as I said at the beginning, my aim with this post is not to denounce all technical indicators. There are in fact a handful of traders out there who have found a set of indicators that work for them, and there is nothing wrong with that.
Finding success in this business is not about finding what works, it’s about finding what works for you.
That said, I have experienced a lot since 2007. Not just in my own trading, but in helping thousands of other traders find success. And one thing that has always stood out is the fact that price action is king.
Like it or not, it’s the basis of everything you do as a Forex trader, technically speaking of course.
So while you can experiment with indicators as you wish, I do urge you to at least learn the basics of price action trading. Doing so will only compliment whatever trading strategy you come up with, regardless of whether it uses indicators or not.
Attempting to trade the Forex market, or any financial market, without first understanding price action is like trying to build a house without first setting a strong foundation.
Every technical strategy on earth exists because of price action. It doesn’t matter if you use a MACD, Stochastic or RSI, they all rely on price action to function properly.
This fact alone should be enough to start seeing price action in a whole new light. It can complement any strategy, regardless of how simple or complex it might be.
Trading with price action isn’t just another trading strategy, it’s the birthplace of every single technical strategy that has ever, or will ever, exist.
What are your thoughts? Do you use indicators, raw price action or a combination of the two?
Share your experience or ask a question below and I’ll be sure to respond.