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"Divergence" for BetterTrades

I love to teach technical trading but I have an aversion to letting technical indicators get out of hand. A recent check revealed over 120 indicators that were available to use on my charts. This is also not including many economic indicators that can be and are used by folks to overlay charts and predict activity.

Whew…

Not only am I not going to try to list them for you I am going to hope you never take the time to search them out. You may or may not even use indicators to trade with. In my Trader’s Forge training workshop I have the student’s trade extensively on the first day using only the chart patterns and the candlesticks. In 5 years of this type of training, no class has failed to make money.

So why do we need indicators if we can trade profitably with out them? Good question. The answer is that once you have developed good trading skills (able to identify profitable targets, entry and exit points, set stops and trade neutral) you can adjust the size or confidence in the trade by consulting certain indicators. By that I mean that when the stock signals a direction the indicators can give you a sense of how strong the signal is. You may then trade 500 shares or 2,000 depending on the strength of the indicator and your confidence level.

The bottom line is that I do not trade or advocate making trades based on indicators only. The stock movement is the ultimate decision maker. I do not care if 35 indicators say the stock is going up. I will trade when it does and if it goes down I will trade it down. I have witnessed a great many occurrences of stocks trading against the prediction of the indicators. So much so that I strongly advocate the indicators be treated as consultants not directors.

Leading indicators;

This is pet peeve of mine. Look, the name itself should tip you off. Oh I know everyone wants to find the Holy Grail of indicators, one that will take the burden off themselves. This is understandable on two levels, first the market is tough to figure out and trade well. People get yo yo’d and whipsawed in between times of thinking they have it nailed down. Secondly it is human nature to want to find a silver bullet or an easy way out. Listen carefully, despite the name being out there in print, THERE ARE NO LEADING INDICATORS. That is, there are no indicators that lead stock movement. The stock price is subject to all kinds of outside influences and no indicators can predict what will happen tomorrow. They may predict movement but it is made up from following data. The most generous title you could give an indicator is that it is a predictive indicator. Time and experience may even give you a good sense of how soon to expect a certain move but it is and will always be, predicated on what actually happens and that is never guaranteed. It is certainly worth setting up a conditional action based on whether the stock actually responds the way the indicator predicted.

That said; there are certain indicators that have had a long history of performance and reliability. It is interesting that there were only a handful of indicators until the computer became widely used by the masses. It is even more interesting that with the proliferation of indicators a small group has stayed firmly ensconced at the top of the preferred list tools. Among the group are several of the oldest and most time tested.

I prefer to use a small group of indicators that are time tested and predictive. I want specialists in key fields of interest like having a small medical clinic with the best neurologist, best oncologists etc. I also do not want to cloud the issue by getting too many opinions. For example I don’t want five neurologists; I just want a great one.

Indicators primarily focus on changes in behavior and trend strength. In other words, is it getting ready to change and/or how strong is the current move? This reflects what people want to know about a stock or a market. This is key to why I cleaned out my indicator closet and tried to make my trading life more simple and manageable. I had accumulated four over bought / over sold indicators, a few trend strength indicators etc. What survived was the Three Amigos who were later joined by a fourth making the Four Musketeers. I use these, as I said, as consultants and never let them override trading what the stock is actually doing.

I use these four musketeers along with candles and volume, however, I do not consider candlesticks and volume as separate technical indicators. I consider candles just a clarification of the line chart. It adds great value to the interpretation of the mood and momentum of the traders. Volume is not a technical indicator per se. Ooooh, blasphemous statement to some. Hold on now… It is a single data point, like pulse, where as all other indicators are made up of multiple data stream comparisons to make disease diagnosis. So I do not lean on volume too much as it is just a measure of interest level and fluctuations can be misleading and can be the result of very significant of very benign events. Let me explain, volume that coincides with news is like predicting rain by looking out side and stating whether it is raining or not. The barometer is the predictive indicator that suggested it yesterday. The most important volume activity would be significant variations of normal activity absent any news, or in opposition to the expected result from the news. The strongest volume signal actually comes when it remains normal in the face of significant price movement either up or down. That gives the strongest confirmation of the move.

Now the clincher. On your seat’s edge you are waiting for the list… right? Well that proves my point. Relax… remember I said you should be able to trade with out them? If you are so desperate for the secret formula it may be telling you something.

Ok, OK, remember this is a series, so I will give you the list but the details will follow in the next newsletter.

First is Moving average with convergence and divergence, MACD. Second is Welles Wilder’s Relative Strength Indicator. Third is Stochastics and fourth is Average Direction Index ADX, also by Welles Wilder.

I hope to see you all in a Trader’s Forge Training workshop soon. Nothing takes the place of skill and nothing builds skill levels like training with a coach in a concentrated and focused environment. The FORGE is your chance to build trading and charting skills. You will learn to use the indicators in a powerful and sensible way. By that I mean, your skills need to be to enhanced by the wise use of indicators and not dependent on them. Remember, YOU should seek to become the magic bullet, not some indicator. Check the dates and get your self enrolled.

See you there.

Ryan Litchfield with BetterTrades