As a general rule I’m not a massive fan of technical indicators. (I’m talking about things like stochastic indicators, MACD, RSI and all those other exotic sounding tools.) ThinkstockPhotos-503315533

If you’ve been following my stuff for a while, you’ve probably noticed I lean more towards pure ‘Price Action’ when it comes to technical analysis – and that means following the 3 core dimensions of any market’s movements: price, time, and volume.

Now I’m not saying indicators can’t or don’t work – many traders make a good living from using them exclusively! But technical indicators do take the data from the 3 core dimensions and then manipulate it in some way via mathematical formulas and computations.

And the results are then delivered onto your chart by way of a visual ‘indicator’.
So it might be a line overlaid onto your candlestick chart. Or it might highlight pre-defined conditions in a special way – it could change the background colour of the chart, or put coloured dots underneath certain candlesticks that fulfil a specific criteria.

Some of them even paint a blatant ‘buy’ or ‘sell’ arrow on your chart.

But one problem I always seemed to experience with indicators is the time-lag factor.

By the time the market-action that an indicator refers to has printed, the bulk of the move can already be over. And trading like that can often be a frustrating case of chasing your tail.

Why I prefer price action over indicators

So why not take a sneaky shortcut, cut out the middleman and go straight to the source? Learn to read the price action of the market directly and you simply can’t get any closer to the coalface.

Trading direct off the price-action can also help you avoid ‘analysis paralysis’. That’s where you might have a range of conflicting indicators with some suggesting the market is likely to move higher, but some suggesting the market is likely to move lower. It can make traders freeze in confusion – they have no clear idea of what they should do.

Now, like I said earlier, I’m not saying indicators cannot add value to your trading, but for me they tend to get in the way. They’re derived from elements we already have direct access to, so why not learn to read the market’s price action and be totally in control of your own trading?

When you trade using indicators you’re always relying on someone else’s interpretation of market conditions. Remember, someone had to program the way the indicator works in the first place!

So I would definitely urge you to develop your skills using price, volume and time.

But going fully naked on your charts can be a big step to take all at once, especially if you’re already used to seeing those indicators lines in place.

But what if there was a ‘halfway house’ – a way of focusing on price action and then gaining an additional edge from applying one certain type of indicator too?

Well, the good news is I think there is.

Here’s a way you could develop your price-action-reading skills while filtering the buying/selling decision with moving averages.

The moving average doesn’t give you a trading signal itself, but it does tell you whether you should look for buy trades or sell trades. And having a clear way of getting yourself pointed the right way around in the market like this gives a big head start to any campaign.

What are moving averages?

First of all, let’s have a quick look at what moving averages actually are. There are two commonly used types:

1) Simple Moving Averages (SMA) are calculated by dividing the sum of the closing prices of a range of candles by the number of candles in the range.

A 100 period SMA adds up all 100 closing prices in the range and divides them by 100. A line is then plotted on the candlestick chart at the resulting price. Each new candlestick replaces the oldest one in the range so the line is constantly being updated as the market moves up or down.

2) Exponential Moving Averages (EMA) work in a similar way to SMAs but they are weighted to give greater importance to the more recent candlesticks. It’s a way to get the indicator reacting quicker to recent developments in price.

Now there are a number of ways traders use moving averages. They might use a 100 period SMA and buy as price moves up through it, and sell as price moves down below it. They might use a combination of moving averages where they generate buy and sell signals from the 50 SMA moving above/below the longer period 100 SMA. That’s called a ‘crossover system’.

But I think moving averages can be most useful when used as a directional filter. They can help you decide whether to trade to the long side – anticipating movement higher – or to the short side. And you can then use the price action to actually get you into and out of the trades.

Let’s have a look at a simple way to do it.

Here we have a day’s worth of activity on the 5-minute chart.

I’ve overlaid the 100 period SMA – that’s going to give an indication of the longer-term picture in this market – and I’ve also used a 34 period EMA which is a ‘faster’ indicator line.

You can see how the 34 EMA dips above and below the slower 100 period line. We can now use the position of the moving averages as a filter to help us trade to the long side when the market looks like it might be ready to move higher and to the short side when the market looks ready to move lower.

So you can use the moving averages to give a directional bias and then make the actual trade entries and exits from price-action-based triggers… things like your candlestick patterns, patterns from price movement, Fibonacci levels etc…

If candlesticks are above the 34 EMA, which is in turn above the 100 SMA, you trade to the long side. If the candlesticks are below the 34 EMA, which in turn is below the 100 SMA, you trade to the short side.

Here’s how you might have traded this chart.

So there’s an example of how indicators might assist you with your trading decisions, especially when you first start out with price-action-based trading.  

I don’t think they should be relied upon in isolation. Try to keep your main focus on price, time and volume!

I like to think of treating indicators how a pro golfer might treat advice from his caddy: he’ll take tips on club selection and he’ll listen to advice on the layout of the golf course, but it’s the golfer himself who must address the ball, take a backswing and take that shot at the pin!

Be Prepared: Market Moving Data Coming This Week (London Time)

Wednesday 16th December
08:30    EUR    German Manufacturing PMI
09:30    GBP    Average Earnings Index
09:30    GBP    Claimant Count Change
10:00    EUR    Consumer Price Index
13:30    USD    Building permits
19:00    USD    Interest Rate Decision & FOMC Statement
19:30    USD    Yellen Speaks

Thursday 17th December
09:00    EUR    German IFO Business Climate
09:30    GBP    Retail Sales
13:30    USD    Philly Fed

Friday 18th December
06:30    JPY    Bank of Japan Press Conference

Monday 21st December
– no big reports

Tuesday 22nd December
13:30    USD    Gross Domestic Product
15:00    USD    Existing Home Sales

So it’s all about the US Federal Reserve’s decision on interest rates this week (plus, the market will be scanning for any out-of-place wording on their statement released at the same time). Things could get a bit jumpy on Wednesday night!

Until next time, happy trading!