There is no “Holy Grail” indication that will guarantee profits in the forex market, as most technical analysis classes would tell you.Â
That is not to say you should abandon your hunt for the “best” technical indicator that works for you.Â
Remember that you may always combine indicators or change their settings to create a consistently effective approach. The possibilities are endless.Â
But, before you get overwhelmed by all of your possibilities, start by answering the following four crucial questions:
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1. What do you want to use the indicator for?
As with other activities, the choice of tool or equipment is dictated by what you want to perform with it. You don’t use a wide camera lens to take pictures or a bread knife to slice steak, do you?Â
If you wish to track patterns, then moving averages can be the ideal alternative.Â
If you like spotting market tops and bottoms, oscillators such as Stochastic or RSI may be your best choice.Â
If you’re scratching your head and wondering what’s going on, return to our School of Pipsology and brush up on momentum indicators and oscillators!
2. Do you know how the indicator works?
Next, in order to properly analyze the signals generated by the technical indicator, you need to understand how it is calculated.Â
To comprehend the output, you don’t need to remember the complicated formulae, but it helps to know what sort of data is fed into them (for example, the average of the past X closing prices or the ratio of highs to lows in the preceding X bars).
3. When does the indicator fail?
Understanding how the technical indicator operates is insufficient. Awareness of potential failure points is also helpful.
Since there is no sign that guarantees success 100% of the time, you need to be aware of situations in the market when it may not perform as well as you’d hoped.
If you blindly follow crossovers, for instance, you might get caught up in turbulent price movement since moving averages don’t generate trustworthy indications in range bound situations.
If you depend on leading indicators with the improper settings, you may be fooled by oscillators that predict reversals too early.
Now for the last inquiry…
4. What settings should you use?
Assuming you’ve already determined the indicator(s) to utilize for your approach, it’s time to choose the appropriate settings.
Remember that shorter/lower settings result in more sensitive indicators that create more signals. Longer/higher settings, on the other hand, produce fewer signals and have a latency.
Where is the ideal setting between this whole range of sensitive and often faulty signals on one end and trailing but more reliable ones on the other?
Some argue that the default settings are often the best since they are what most market observers use anyhow. This essentially implies that they have a self-fulfilling impact.
However, if you prefer settings that can integrate the most recent market circumstances or have a solid track record with other indicators, backtesting may be the solution.
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5. Bottom line
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