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The Traders Wheel
9/12/99 by Alan Farley

Garbage In, Garbage Out

 

Chart patterns and technical indicators are not created equally. A highly skilled technician can trade successfully using only a price bar chart. But the most powerful set of market indicators has little value when viewed in the absence of price. Just try this exercise: buy a stock at "oversold" and sell it at "overbought" without looking at price. Not a good way to make money.

Chart patterns reveal quirks of crowd greed and fear behavior. They are universal fractals that repeat themselves over and over again in all time frames. Best of all, they point to the exact locations for low risk trade opportunities.

But the mind plays tricks on what the eye perceives. The human brain attempts to construct order from visual chaos. Randomness fed to the mind responds as perceived pattern. Unfortunately, this false order may tranquilize the eye but lacks truth or predictive power. And it destroys trading accounts.

Newer traders should never rely solely on patterns for trade execution. Reading price patterns requires little effort while serious study is needed to interpret technical indicators. So many newbies take the easier path and fail miserably when their profit depends on correctly interpreting these complex tools.

Technical indicators filter out the bias of the organizing brain. Physics teaches that energy sources leave telltale signatures in the form of exhaust or radiation. Similarly, patterns with true predictive power should emit evidence that indicators can detect and measure. When signals converge through these discontinuous forms of analysis, odds increase sharply that the trade setup is valid.

Shorten your learning curve by understanding two common quirks of indicators.

Over the years, endless variations of the same few studies have been published. Stick with the classics until they stop working for you. And regardless of origin, all indicators suffer from the same limitation. They only work in certain market conditions. Learn what those conditions are before you trade.

Overbought? Common wisdom says to sell when Stochastics punches above 80. But that advice would have cost you money during PSFT’s 100% gain in 1998. Always look to the pattern first before interpreting your technical indicators. In this case, the only important message was "the trend is your friend".

 

 

 
Alan Farley is a full-time trader and author residing in Denver, CO. He publishes The Hard Right Edge premier web site for trader education, technical analysis and trader resources featuring both Morning Trader and Traders Workshop. The site provides traders with comprehensive resources including original tactics and strategies on multi-trend technical analysis and short-term trading .

  Alan also authors on-line training technical analysis in association with independent sites. His most recent publications include the Mastering The Trade on-line workshop, Momentum: Riding The Tiger, and Time of Day. In addition to writing, he is an outstanding speaker and lecturer on short term trading strategies.

 He has been featured in Barrons, Smart Money magazine, Tech Week, MoneyCentral and TheStreet.com.

 

 

 

 
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Last modified: April 02, 2001

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