As most technical analysis courses will tell you, there is no “Holy Grail” indicator that can guarantee profits in the forex market.
That doesn’t mean you should give up the search for the “best” technical indicator that works for you.
Don’t forget that you can always mix and match indicators or tweak their settings to come up with a consistently profitable strategy. The possibilities are endless!
But before you get overwhelmed by all the options, start off by answering these four key questions first:
1. What do you want to use the indicator for?
As with most activities, the choice of tool or equipment boils down to what exactly you want to do with it. You don’t use the wide camera lens for shooting portraits or pick up the bread knife for slicing meat, do you?
If you want to follow trends, then moving averages might be the right option.
If you like catching market tops and bottoms, then oscillators like Stochastic or RSI could be your best bet.
If you’re scratching your head and wondering what all this is about, then you should go back to our School of Pipsology and read up on momentum indicators and oscillators!
2. Do you know how the indicator works?
Next up, it’s also important to have an idea of how the technical indicator is calculated in order to better interpret the signals it generates.
You don’t really have to memorize the complex formulas, but it would help to know what kind of data goes in (ex: average of last X closing prices or ratio or highs vs. lows in the previous X bars) to understand what kind of data is churned out.
3. When does the indicator fail?
It’s not enough to just know how the technical indicator works. It’s also useful to be alert to when it could fail.
After all, there is no foolproof sure-win indicator out there, so you should be mindful of market scenarios wherein it might have some drawbacks.
For instance, moving averages don’t really give reliable signals in rangebound markets, so you might get caught up in choppy price action if you follow crossovers blindly.
Some oscillators tend to anticipate reversals too early, so you could get prone to fakeouts if you rely on leading indicators with the wrong parameters.
This brings us to the last question…
4. What settings should you use?
Assuming you’ve already decided which indicator/s you want for your strategy, it’s time to figure out the right settings to use.
The key thing to remember is that shorter/lower settings lead to more sensitive indicators that generate more signals. On the other hand, longer/higher settings give less frequent signals and tend to have a lag.
Between this whole spectrum of sensitive and often unreliable signals on one end and lagging but more reliable signals on the other, where is the perfect setting?
Some say that the default settings are often the best ones since it’s what most market watchers use anyway. This basically means that they tend to have a self-fulfilling effect.
But if you prefer settings that are able to incorporate the latest market conditions or have a good track record with other indicators, then the answer could be found in backtesting.
