Sentiment in the Forex Market: Indicators and Strategies to Profit from Crowd Behavior and Market Extremes

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CHAPTER 6

The Power of

Technical

Indicators

T

he method that is referred to as technical analysis encompasses

a wide array of techniques, including moving averages, oscillators,

point and figure charting, candlesticks, time cycles, pivot points,

trendlines, traditional chart patterns such as the head and shoulders, and

tools derived from Fibonacci mathematics (which is the mathematical

foundation for Elliott wave analysis). I will cover just a few of these in-

dicators. There are so many indicators, and many new traders feel over-

whelmed when it comes to deciding what technical tools to use for their

trading. Technical analysis is only valuable if the person using it is disci-

plined. Once you develop a trading method robust enough that you feel

comfortable risking real money, it is imperative to be consistent and stay

with that strategy until further analysis suggests otherwise. Exploring and

testing new methods is always important, but hastily changing your trad-

ing style because of a few bad trades destroys the advantage that technical

analysis provides in the first place. That advantage is objectivity. The fol-

lowing hypothetical example sheds light on this matter.

A trader using a moving average to determine a directional bias might

decide to take long trades if price is above the 21-day simple moving av-

erage and take short trades if price is below the 21-day simple moving av-

erage. There is nothing subjective about price being above or below the

21-day simple moving average. Price is either above or below the aver-

age: end of story. On the other hand, two traders could argue all day about

the relationship between the Dow and the U.S. dollar. There is no consis-

tent relationship, by the way; the Dow and the dollar sometimes advance

together, decline together, and sometimes move in completely opposite

101

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102 SENTIMENT IN THE FOREX MARKET

FIGURE 6.1 There is absolutely no consistent correlation between the Dow and

the U.S. dollar

Source: Chart created on TradeStation

R



, the flagship product of TradeStation Tech-

nologies, Inc.

directions. See Figure 6.1. Both traders can sound convincing but at the

end of the day, their opinion is just that. A moving average is objective, and

the opinions of the traders arguing about the Dow and the U.S. dollar are

subjective.

However, say that the moving average trader suffers a few bad trades

in a ranging market. After all, a moving average is a trend-following indica-

tor and moving average strategies get destroyed in range bound markets.

The trader is discouraged and makes an emotion-based decision to switch

methods. Remember, the decision to trade the moving average system was

made rationally after testing was performed. The decision to change meth-

ods and try something else was made emotionally due to the pain of losing

money. Of course, immediately after changing strategies, the market enters

a trending period. The losses suffered would have been more than offset

had the trader in this example had the discipline to stick with the moving

average strategy.