Understanding why technical indicators fail

Trading signals and indicators form part of the basis of technical analysis of trading trends and market movement. These tools are used by most traders to analyze price action and plan entry and exit strategies. Although these are popular in CFD, stock and forex advice and often work well, no technique in the trading industry can guarantee success. In order to use indicators correctly, you need to understand the risks and why they might fail.

Lagging indicators

A lagging indicator comes with a signal after a significant event occurs on the chart. This essentially means the indicator lags the price action after the event. The two most commonly used of these indicators are the simple moving average (SMA) and the moving average convergence divergence (MACD).

An SMA indicator can fail by leading you into losing trades if the price reverses unexpectedly. False signals given to indicate a trend can be misleading and can cause you to lose on your trades if the price moves in a contradicting direction to what the signal suggests. MACD signals can also be misleading if, for example, they indicate a bearish trend but then the price begins to increase. Situations like these are often found during midday sessions on the market day because there is a lower volume, making it easier for small traders to move stocks around unexpectedly. One way to avoid this potential trap is to either lower profit targets during this trading session or learn how to identify potential volatility.

Leading indicators

A leading indicator does exactly what its name implies and signals a price move as it begins. This allows you to identify a trend at its start and place trades to ride out the forthcoming movement. In theory, this sounds like a great advantage when you’re looking for profits in stocks, shares and forex trading, and it often can be. However, it also comes with its share of risk. There are two types of leading indicators: the stochastic oscillator (SO) and the relative strength index (RSI).

An example of a false RSI indicator would be if, at the beginning of a chart, the price and relative strength index both begin to decrease. The RSI line breaks into the oversold region, breaks upward and indicates a long signal. The price would then be expected to increase, but instead it experiences a short decrease. This might occur again on the chart before the price increases, creating a bullish signal. However, the price remains relatively flat only to drop drastically at the end of the chart. If you had followed the original indicator, you would have lost in your trade.

A false stochastic oscillator signal can be found in a situation where the charts begins by decreasing only for the SO to reflect strongly in the oversold region. The indicator then experiences several upward breaks of the oversold area, which would usually be a signal to buy. However, the price remains flat and eventually drops drastically. This reveals the opposite movement of what the SO initially revealed, and if it were traded, it would lead to a loss.

The reason false indicators occur

Technical analysis is based on past price trends that predict overbought and oversold regions on the chart. Therefore, the analysis cannot entirely determine what will happen in the future. It has become more difficult to conduct technical analysis because of the increased volume of trades in recent years. This causes more volatility in price action and produces risks. However, despite not always being accurate, this method of trading can work and lead to success when it is studied and applied correctly. This is done with the use of risk management. Your trading strategy might succeed often, but protecting your trades remains crucial. It is up to you to determine which risk management method will best suit your strategies and how you can implement that method.