Maybe you've had the same experience? You look at a chart with indicators, recognize clearly recurring patterns and start to act on them. Initially you make good profits. But to your fright, they suddenly turn into a losing streak. This not only consumes your previous profit, but also destroys your capital bit by bit. Our cover story should show you how to work successfully with indicators in the long run and when you should better keep your hands off them.
Welcome to the world of indicators
Technical indicators are not a reinvention of recent years. As early as the 1980s they were used to form opinions and make decisions due to the increasing use of computers in stock exchange trading. The well-known Bollinger bands*, for example, were developed in the 1980s. All these indicators mainly supported professional traders and analysts at banks and trading houses in their trading decisions. For private customers, the world of indicators did not open up until the end of the 1990s with fast Internet connections and low-cost trading opportunities via direct banks and brokers, who usually make the software available free of charge. If you take a closer look at indicator strategies, you will unfortunately find that they are not self-propelled and even experienced traders regularly generate losses with them. Many new investors see indicators as a miracle cure to make profits and achieve hit rates of 100 percent. Sooner or later, however, they realize that this is unfortunately not the case. The goal of stock exchange trading cannot be to successfully conclude every trade. Rather, the bottom line is that money must be earned. Old master André Kostolany already stressed that it is enough to be right in 51 percent of the cases. This also applies to trading strategies based on indicators.
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Why do indicator-based trading strategies work?
"The price has just risen above the 200-day line, which will give it an extra boost." I'm sure you've heard something like this in one or two market commentaries. Why is that? Fundamentals may not have changed. So the price should only continue to rise because a mathematical level determined from historical prices has been reached? What seems illogical at first glance often turns out to be a self-fulfilling prophecy. It is proclaimed in a much-noticed market commentary and only because of this fact does further demand arise in the market.
Indicators such as the 200-day line (average of the last 200 daily closing prices, also known as the moving average) are easy and unambiguous to determine. In the relevant literature there are quite similar interpretations of the indicators. For example, if the price exceeds its Moving Average on a closing price basis, this is interpreted as a bullish (upward trend) signal. If it falls below its Moving Average, you receive a bearish (downward trend) signal.
Because both calculation and interpretation are simple and at the same time widespread and much observed, at certain times similar interests come into the market. As a result, the signals determined by the technical market indicators achieve a good hit rate.
You can also use this if you know how different indicators work. In addition, you will find a flood of information on the Internet and in books; therefore, no further indicators are presented here. It is much more important for you to learn how to use indicators to develop your own strategy.
How to find the right indicator?
Dirk Friczewsky - entrepreneur, trader and financial market expert - gives valuable tips to find the right indicator for your trading style.
How to develop trading strategies?
Are you a trader who checks stock prices irregularly or do you invest a lot of time in trading? On the stock market, it's the same as in any other environment: the more time you invest, the better your results will be. A scrap metal trader, for example, will not be successful in his profession if he is not deeply involved in the market. This also applies to the stock market: If you trade a stock such as the EUR/USD or the DAX, you need to know how this market behaves. The basis of a good trading strategy is therefore regular market observation.
Choose a chart on which you want to trade, for example the 30-minute chart. Now add indicators that you have already informed yourself about and that you think are promising. Moving averages (for example a GD over 200 as well as 30 periods) should not be missing as basis. You can also work very well with Bollinger bands or envelopes. Now the actual work begins: Your task is to find patterns in charts and indicators that appear regularly. For example, you might notice that in a sideways market the Bollinger bands work very well as upper and lower limits and the price moves back to its average price after touching them. Or, you may notice that in most cases the price does not move more than one percent away from its average price, and then a counter-movement occurs.
Admittedly, this work is tedious and requires a lot of time. As mentioned earlier, your success on the stock market will depend not least on your commitment. The longer you observe a chart (preferably over several weeks and months), the better your feeling for the price development will be. In order to illustrate the procedure for developing a strategy based on indicators in a transparent and descriptive way, the so-called "DSMA strategy" will be explained below.
Image 1: Trading Signals of the DSMA Model
Image 1 shows a 60-minute chart of the EUR/USD. The black line corresponds to the 120 MA, the red line to the 240 MA. According to the trading rules of the model (see text), there are three long trades for this period (entry signals are the beginning of each arrow, exit signals are the end of each arrow).
Image 1 shows a 60-minute chart of the EUR/USD exchange rate. The 120 and 240 moving averages (MA) are used. After detailed observation of this chart, you will notice that under certain conditions a trend reversal occurs regularly. These are defined below for long trades and vice versa for short trades.
- 1st condition: The 120 MA must be above the 240 MA. If this condition is met, the closing price of the candle is observed. This means that the following criteria are examined at the beginning of each new hour:
- 2nd condition: The opening price of the just completed candle must be above the 240 MA.
- 3rd condition: The closing price of the just completed candle must be below the 240 MA.Or in other words: If the shorter one is above the longer average, the opening price of a candle is between and the closing price is below both average lines, then a long position is taken in this strategy. The strategy thus assumes that the setback in the prevailing upward trend is of a temporary nature. Subsequently, as part of money management, this order is provided with a stop loss of 0.5 percent and a profit target (take profit) of initially 1.0 percent.
For the optimal exit, you could make the following observation in the chart, which you then defined as the take profit rule in the event that a percentage price target has not (yet) been reached: As soon as a candle closes above the short MA, the long order is closed at the opening price of the next candle.
In the remainder of this article, this simple set of rules will be referred to as the DSMA strategy. DSMA stands for "Double Simple Moving Average", i.e. the combination of two linearly calculated moving averages.
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Are you sticking to your plan?
Surely you have already been trading in anticipation of a certain price target. You quoted your stop-loss price, but did not place an order with the broker. As the price moves against your forecast and approaches the stop-loss level, you throw your original plans overboard and continue to correct the stop-loss price - but ultimately the loss becomes bigger and bigger. Or you may be tempted to take profits far too early, contrary to your original plans.
At this point it is particularly important that you define the rules for your strategy in writing! This makes it easier to stringently implement the plan in all eventualities and especially during all psychological traps.
A written set of rules is an essential factor for all successful traders and has several advantages. On the one hand, you are able to automatically implement your rules in a computer program (such as an Expert Advisor (EA) on the widely used MetaTrader trading platform). This means that you do not commit yourself to implement the rules, but "commission" a computer. This computer strictly adheres to your specifications, so that human inadequacies in trading are ruled out. On the other hand, you can only backtest the strategy with fixed rules. This historical calculation of the theoretical trading success of your system is ultimately necessary in order to determine whether the strategy can even lead to the desired profit. If you change your trading strategy again and again, you will never be able to determine whether the model is able to generate profits. Finally, the strategy must be implemented exactly as you defined it in your trading plan - manually or automatically.
Why do most traders make losses?
At the beginning of the article it was stated that several traders have come across a "super strategy". However, as soon as they trade them with real money, the hoped-for profits only occur for a short time; afterwards, losses must be realized that exceed the just made profit. Many investors assume that there must be a kind of master strategy that can - almost - realize 100 percent profits in every market phase. If this were the case, why do so many doctors of physics and mathematics sit in the proprietary trading of the large investment banks? Wouldn't it be enough for these people to develop such a master strategy once and then be successful with it in the following years?
The truth is: the markets are constantly changing. Depending on the mood on the stock market and the economic situation, market participants will not always behave the same, but will always adapt their buying and selling habits as well as their risk appetite to the current situation. As a result, the markets continue to develop on a regular basis. In order to describe the current phase of the market, four basic segments can be distinguished: Steady and volatile trend markets as well as sideways markets with low and high volatility (fluctuation margin). If you have found a strategy that is optimal for sideways markets and the market is now entering a trend phase, you will probably make losses with this strategy - although it may have worked wonderfully in the last few weeks. Even if the sideways trend remains intact, but the volatility increases somewhat, it could happen that your originally defined stop levels are reached with larger price fluctuations and you generate losses, even though your price target turns out to be "right" in the end.
What consequences does this have for your trading strategies? If you do not consider the different market phases in the selection of your strategies, you can hardly be successful on the stock exchange in the long term. This can be clearly seen from the capital curve of the so-called "rebot strategy", which flowed into the trading signal publications of the authors until mid-August 2012. This is a trend-following strategy which, as soon as the EUR/USD makes a strong move within an hour, enters this trend, i.e. follows the market direction.
Image 2 shows how a starting capital of EUR 20 000 has changed over time when applying this strategy (capital or equity curve). Fees in the form of the bid-ask spread of the broker (the so-called "spread") have already been taken into account here, which is why this is the net development (the volume of each trade corresponded to the capital employed) without leverage. It can be clearly seen that this strategy has been consistently profitable since April 2010. In relation to the entire period from January 2007 to June 2012, however, the return would have been around zero percent, as it was sideways or negative between 2007 and mid-2010. If you define different strategies that work well and then backtest over a long period (five years or longer), you are very likely to find that - almost - all these strategies generate losses over one or more longer periods. Consequently, not only the development of a very good trading strategy through sustainable market observation is important, but also the correct use in the appropriate market phase. This will ultimately determine your success to a large extent.
Image 2 shows the capital curve of the rebot model. It can be clearly seen that the model has both profit and loss periods due to different market phases of the EUR/USD.
Finding the right market phase
How can you tell which phase the market is in at the moment? And how should you act in this market phase? Basically, there are two ways to do this: Either you decide for yourself which phase of the market is currently predominant and act accordingly. Or you let objective mathematics decide.
With the first option, you have to decide discretionarily which market phase you expect in the coming weeks and months. This procedure is associated with the risk that the decision will turn out to be wrong afterwards. Furthermore, additional research is necessary as these decisions are partly based on fundamental data.
It is much simpler and yet effective to choose a mathematical approach to determine the current market phase. The aim here is not to describe the market phase in words such as sideways or trend market. Rather, you are targeting the question of whether the chosen strategy works in the current market or not.
Suppose you have developed a strategy that is very successful in trend markets. How can you tell whether there is a trend market? The answer to this question may seem banal, but it is very effective: As long as the strategy generates profits, the right market phase prevails. In other words, you let the strategy itself see whether the current market phase is appropriate. To illustrate this, the DSMA strategy described above will be discussed again here. Figure 3 shows how a starting capital of 20,000 euros would have developed if trading with this strategy (equity curve). It can clearly be seen that longer loss strands were recorded. It was not until 2010 that there was a market phase that fitted the strategy perfectly.
Image 3: Equity curve of the DSMA model
Image 3 shows the capital curve of the DSMA model to EUR/USD. Here, too, it can be seen that the model sometimes generated no or even negative returns over a longer period of time.
What exact mechanism should the strategy or model use to determine whether a favorable market phase prevails at the moment? To determine this, plot a moving average on the equity curve. Trading in the strategy only takes place if the current status of the equity curve is higher than the average line. If this is the case, it is a clear indication that the strategy is currently making profits. The assumption now is that this phase will continue until one or more loss transactions push the equity curve back below its own moving average.
This procedure may seem complex at first glance, which is why it is also shown graphically in Figure 4. You can see from the equity curve how this procedure affects the DSMA strategy. The blue line describes the classic equity curve of the model from January 2007 to August 2012 (analogous to Figure 3). The red line is the average of the last three points on the equity curve (i.e. the last three trades). After this filtering (hereinafter also referred to as "filter strategy"), trading takes place only if the blue line is above the red line, as in this case the market environment is favourable for the model. If the filter strategy is used, then fewer trades will take place than with the original strategy. You can see the result by the yellow line, which describes the equity curve achieved by the market phase filtering. At several points on the yellow line you can see that it is sideways. This means that you are omitting trades of the original DSMA strategy in live trading and only executing "on paper" - or with greatly reduced trading volume. However, the continuation of the original strategy as paper trades is absolutely necessary in order to be able to calculate the moving average on the original equity curve at any time.
Figure 4: Equity curve of the DSMA model with MA filter
Image 4 shows the capital curve of the DSMA model (blue) and a moving average of 3 (MA, red) on this curve. The yellow line represents the capital curve of the DSMA filter strategy. The market phase filter can improve the result and significantly reduce the drawdown.
Result of the Market Phase Filtering
In addition to the additional profit clearly visible in image 4, the filter method reduces the risk of the strategy. While the classic strategy (blue line) goes through several up and down cycles, the downside potential of the filter strategy is much lower. You can measure this using the drawdown (maximum loss phase measured in account currency or percentage of capital). For the DSMA strategy described above, the maximum drawdown is 6.54 percent. Market phase filtering using the moving average on the equity curve reduces the drawdown to 2.37 percent.
The market phase filter has a further positive effect on the total return. Conversely, the reduction in the drawdown allows a leverage of 2.76 (6.54 divided by 2.37). With this leverage, the drawdown of the filter strategy then corresponds exactly to the drawdown of the original strategy, but now with a significantly higher return (see Figure 5). Filtered and leveraged with a factor of 2.76, the DSMA strategy generated 6.88 percent per year in the linear recalculation over a good five and a half years (capital increase from 20,000 to over 27,500 euros corresponds to just under 39 percent total return, see green line in Fig. 5).
Image 5: Equity curve of the DSMA model and levered filter
The drawdown of both strategies is identical at 6.54 percent. Due to the market phase filtering, however, the return of the filter strategy is significantly higher.
This means: If you want to take an even higher drawdown risk due to your higher risk affinity, you can easily do so with the help of the filter strategy: For example, if you want to invest a maximum of 20 percent of your equity, you can triple the leverage again (6.54 percent drawdown times three). Historically extrapolated, this increases the return opportunity to over 20 percent per year. The DSMA strategy presented here, combined with market phase filtering, reveals an important finding: a solid, risk-adjusted model does not lead to rapid gains that multiply your capital in just a few weeks. Rather, a sustainable strategy has a manageable risk, a constant positive development and above all requires time and patience. Only a patient investor who has confidence in the strategies he has developed will be successful on the stock market in the long term.
More than 100 indicators are available in the NanoTrader with one click as well as more than 60 ready-to-use strategies for direct use. You can test them immediately and free of charge.
In this article you have certainly not found a method that will make you a millionaire overnight. Successful trading always involves a lot of personal effort. You have certainly already made this experience yourself. However, you will find here a very good guide on how this work can be structured and targeted to make your trading strategies permanently useful. The market phase filter strategy presented uses simple mathematics (averaging) to show you whether your own trading rules with indicators fit the current market phase or not. In the long run, you can reduce your loss phases, even increase leverage and accumulate profits in good phases.