How do indicators actually perform

  "A recent study of the Stochastic and RSI indicators show they are right only 55% and 50% of the time. They are like flipping a coin over the long term. That means you cannot trade them and win over the long haul because they don't cover the spread, interest, etc that constitute the "House Edge"--------

This study was done by Humble Traders using a 1 year period on the EURUSD- the most traded currency pair in Forex.

I guess you use some technical indicators in your trading?
Do you know how probable or accurate are the indicators you use?
For example, lets take a classic stochastic indicator;
If the indicator goes

  • below 30 line, we buy and
  • If it goes above 70 line, we sell

This is a classic use of the stochastic indicator. It’s obvious to most of traders, right?
Sadly, nobody is able to tell me how the indicator performs in the real time.

  • What is the probability of stochastic oscillator to generate a winning trade?
  • Would you still use it if you knew that the probability is 50% or less?
  • You would be better off not to use it and pick the trade randomly, your probability would then increase to 50% (random coin flip).

so

I looked at two most common indicators;

  • Stochastics oscillator and
  • RSI indicator

I used the visual mode in MT4 strategy tester to mimic the real time behaviour of the two indicators. As they are lagging indicators, its totally pointless to test it on already unfolded price action.

Stochastics

  • Buy if: Oscillator is under 20 line and crossed upwards
  • Sell if: Oscillator is above 80 line and crossed downwards
  • Market: EURUSD
  • Time range: Jan -Dec 2017
  • Time frame: Daily
  • Settings: default
  • Winner defined as: closed 50 pips in profit
  • Loser defined as: closed 50 pips in loss

Results:

  • The test generated 20 signals
  • There were 9 losses and 11 winners
  • Stochastic oscillator had proven to be 55% accurate based on this small sample.
  • This is just above the coin flip.

Now you need to consider other variable that would play out in real time (emotions, missing trades, spreads etc). If you look at the chart for this period, you will note how accurate the stochastic oscillator looks. Almost all crosses above and below lines are followed by the price movement in the right direction. Unfortunately, this is not the case in real time. Stochastic is a lagging indicator and will only be fully drawn after the price moves ahead. In many cases, the price moved to take out the stop loss before it moved in the anticipated direction.

From this test we see how little of use the indicator really is, or at least, it looks much more accurate for a human eye. Sadly, the lagging nature of it, makes it really unreliable.

You can try to improve it by adding a moving average or selecting signals with other additional variables or changing stop loss or take profit.

This test is only to show you how to apply probability to the trading tools you currently use.
Do you use stochastics? 
Should you test other indicators to see if you find more accurate one and replace stochastics?
It could improve the accuracy of your strategy right away.

RSI

  • Buy if: is under 30 line and crossed upwards
  • Sell if: is above 70 line and crossed downwards
  • Market: EURUSD
  • Time range: Jan -Dec 2017
  • Time frame: 4 hours
  • Settings: default
  • Winner defined as: closed 50 pips in profit
  • Loser defined as: closed 50 pips in loss

RSI proved to be even less accurate and generated 10 winners and 10 losses over the first 20 signals in 2017. This is a pure coin flip odds or even worse if you account for real time variables in play.

Similarly, to the stochastic oscillator or, in fact to all lagging indicators, RSI is fully unfolded after the price is already ahead in time.

See the results

Many traders randomly use very inaccurate technical indicators
decreasing their chances of success

 

Make sure that you leverage statistics in order to
find, calculate and optimise you edge

Summary
The point to drive home is that trader needs to use statistics and numbers to figure out what works and what doesn’t. The lesson is:

Use maths and statistics to recognise and dump things that looks ok on the surface but are in fact dragging you and your money down the drain.

You should do two exercises:

#1
If you have a strategy at the moment, do you know:
What is the accuracy of your strategy?
What is your risk and reward ratio?
What is your pay-out?
How can you make the above metrics better?

#2
Go through all indicators you use today and calculate how accurate they are.
Do they really help you to achieve results or they are only clouding your perception?
Dump those that don’t work, replace them with those that do.
In the next lesson we will talk about randomness, distribution of good and dad luck.
Markets, finance and trading is a s random as anything else in this life.
We need to be aware of it and be ready for good and bad periods.

From ProAct Traders:

Why not give up on the coin flip of indicators and learn to trade Price Action?

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