Option Investor
Trader's Corner

What's Your Favorite Indicator?

Printer friendly version

Traders sometime ask that question. My answer? That depends.

Trending, range-bound and volatile markets require different approaches. Indicators that work for one type market will lighten trading account balances in another.

Take a look at a range-bound market first. A monthly chart of Dupont (DD) shows that since 2000, DD has remained range-bound between $35.00-50.00, with most prices encapsulated in a narrower range between $40.00-50.00.

Monthly Chart of Dupont:

Clearly, DD qualified as range-bound during that period. In range-bound markets, oscillators such as stochastics tend to work well as predictors of market behavior. On the following daily chart of Dupont from late December 2003 to mid-July 2004, stochastics tops and bottoms demonstrated some congruence with price swing highs and lows. Bullish stochastics crosses up through the lower signal line tended to be good signals for long positions, and bearish crosses down through the upper signal line tended to be good signals for bearish positions. On the chart, bullish entries appear in green, and bearish, in red.

Daily Chart of Dupont:

No signal proves infallible, even if matched to the right type of market. Using oscillators in a range-bound market doesn't either. Depending on exit signals used, bullish signal 2 would likely have resulted in a losing or breakeven play, as would bullish signal 7 and bearish signal 9.

Technicians warn, however, that oscillators such as stochastics prove less useful when markets trend. One example of a trending market was TASR's climb from January through April, 2004.

Annotated Daily Chart of TASR:

In the case of a trending market, some technicians watch the behavior of prices with relationship to key moving averages. In a bullish trend, bounces from an appropriate moving average, perhaps confirmed by another indicator, help pinpoint new entries. Take a look at the same period for TASR, but with the inclusion of the 21-ema.

Annotated Daily Chart of TASR:

The same technique can be applied in downtrends and across different time frames:

Three-Minute Chart of the ES Futures Contract:

Trending and range-bound markets aren't the only types of markets, of course. Choppy markets shouldn't be traded except by adept scalpers, using any indicators. Choppy conditions sometimes show up after an extended move, when markets begin a consolidation and before they've settled into a particular consolidation pattern. Be aware that markets could chop around after such a move, then step aside until you see a pattern develop.

Annotated Five-Minute Chart of the OEX:

Stochastics and other such oscillators might have proven helpful once the rectangular shape of the formation was determined, but the OEX's tight range prevented all but the most adept scalpers from benefiting.

Choppy markets are sometimes volatile, but volatile markets are not always choppy. Periods of expanding volatility sometimes result in a trending play, but the trick lies in catching the moment when volatility expands after a period of consolidation.

Annotated Five-Minute Chart of the OEX:

Most traders would have recognized the choppy trading conditions, but still wanted a way to identify a breakout when it occurred. That breakdown did occur with a trendline break (not shown), but traders might have been too convinced of choppy trading conditions to trust that event. Other tools used to identify expanding volatility include Donchian channels, Keltner channels and thrusts, among others.

One technician defines a thrust as a gap followed by a candle larger than the candle before the gap, with a close near the top of the thrusting candle on an upside breakout and near the bottom on a downside breakout. This technician believes upside breakouts to be more reliable than downside. No such thrust occurred in concurrence with the beginning of this breakdown, whether trustworthy or not.

The creators of both Donchian channels and Keltner channels crafted these channels to identify breakout plays. That's their original purpose, although some traders have since adapted them for other uses. Both types of channels deserve more commentary than can be included in this article, but archived articles discussing these channels in some depth will soon be available.

A couple of charts serve to introduce these channels, however. Note this example of the same five-minute period on the OEX as in the last chart, showing a breakout below a Donchian channel with a period of 20 and an offset of 2.

Annotated Five-Minute Donchian Channel Chart for the OEX:

The Donchian channel identified the breakout. They always catch breakouts. However, a careful examination of the chart reveals false upside breakouts, too, and hones in on one of the pitfalls of trading breakout plays.

Many who study markets suggest that breakout plays provide the most profit over the long run as compared to other types of plays. They sometimes catch big moves. Those big moves amass profit that more than makes up for the unprofitable plays entered while markets chop around as long as losses are kept minimal. Most breakout plays lose money.

Capturing those big moves requires entering on each breakout, however, as it's difficult to identify those that will ultimately prove false and those that would continue to move in the breakout direction. A study of the Donchian channel breakouts above shows that several of those false upside breakouts would have trapped bulls, ending in unprofitable plays. Donchian channels confer no special protection from those traps or from the pitfalls of a trading style that consists of or encompasses playing breakouts.

Exit decisions sometimes prove difficult to make, too. My previous study of Donchian channel breakouts shows that an almost irrational faith in one's abilities and a deep-enough pocketbook to weather long periods of draw-downs are necessary attributes for the trader playing breakout plays using this tool. That investigation also demonstrated that plays are profitable over the long run, corroborating evidence of others.

Keltner channels display similar strengths and weaknesses.

Annotated Five-Minute Keltner channel for the OEX:

Nested Keltner channels may confer a few more benefits than either single Keltner channels or Donchian channels, however. Nesting several channels of different widths inside each other helps set profit targets and identify clusters of support and resistance, perhaps refining entries, too. When examining the following chart, note that it's composed of three separate channels--blue, black and purple. Don't get too caught up in the tangle of lines and what they mean. That's a subject for another article, and one that will soon be available through the archives. For now, you're looking for a break outside one channel, headed to the outer boundary of the next widest.

Annotated 60-Minute Keltner Chart for the OEX:

If I had to choose a favorite tool, that would be the nested Keltner charts because of their versatility. However, these examples confirm that different market conditions dictate the use of different indicators to pinpoint effective trades. Be flexible.

What's my real favorite? The one that works with current market conditions.

Trader's Corner Archives