Definition and Example
Trading based on indicators is a trading method that uses technical analysis to identify market trends. New traders use visual indicators to discover trends in the market. These indicators are not useful for traders who know how to read price charts. Indicators cannot precisely predict what will happen. Use indicators with caution and practice using a trading simulator, especially if you are a new trader.
How Trading Based on Indicators Works
The indicator displays a visual representation of the mathematical formula and price inputs. For a chart reader or an unskilled trader, the indicator might not reveal more than what is visibly apparent through price (or volume) chart analysis without any indicators. Indicators give you a visual cue on how prices are moving.
For example: You log into your favorite trading platform and choose the market you want to participate in. Most platforms allow you to select your preferred chart type and offer various indicators.
The trading platform then automatically performs the mathematical calculations to display the indicators you have chosen. In the chart below, you can see Apple’s (AAPL) long price drop that started in early April. Throughout May, the moving average (blue line) continued to decline. The trader noticed this indicator a few weeks into April and would begin investigating the circumstances surrounding the drop. Once they are comfortable with the information supporting the moving average, they will make trades based on their forecasts regarding the stock.
Types of Trading Strategies Based on Indicators
There are thousands of indicators, and new indicators are continually being created. There are also many ways and trading strategies that involve indicators, but generally, they all fall into one of the following two categories.
Crossing Strategies
The price or an indicator can cross with another indicator. The crossing of price with the moving average is one of the simplest indicator strategies.
An alternative version of the crossing strategy occurs when the short-term moving average crosses the long-term moving average. This type is referred to as “moving average crossover.”
Crossovers happen in many indicators. For instance, moving averages provide crossovers when the MACD line crosses over the signal line or when the MACD line or signal line crosses above or below zero. Signal indicators are typically moving averages, but they are not used as an indicator in these strategies. Instead, they are used alongside other indicators to generate trading signals.
Other crossovers include the Relative Strength Index (RSI) signal when it moves above 70 or 80 and then falls back below, indicating an overbought condition that may be reversing. Similarly, falling below 20 or 30, followed by a rise above 20 or 30, may signal an oversold condition that could be alleviated by a rise.
Uptrend and Downtrend Strategies
Many indicators serve as confirmation tools. If a trader sees an uptrend on the price chart, indicators like RSI, MACD, and moving averages (along with many other indicators) help assess the strength of that uptrend. These indicators also assist in confirming trend reversals and downtrends.
Advantages and Disadvantages of Trading Based on Indicators
Advantages
Simplification of price movement: Indicators make it easier for you not to need to understand what is happening to make the chart move up and down. Ease of interpretation: New traders may find the simple movements of indicators easier to interpret than price chart fluctuations. It should be noted that “easier” in this case does not mean “more profitable.” Indicators are excellent tools for learning how to spot weakness or strength in price, such as when a trend is weakening.
Excellent
For training: New traders may find evaluating the price chart challenging, but with the help of some indicators, they are informed of subtle changes they have not yet trained to see on the price chart.
Disadvantages
Price movement disclosure only: The indicator shows a visual representation of the mathematical formula and price entries. Indicators cannot predict what prices will do in the future. A moving average may continue to decline, but that does not guarantee it will continue in that direction. They do not benefit skilled chart readers.
What does this mean for individual traders
These are just examples of strategies and indicators, not recommendations. Every trader should find the indicators that work for them and generate profits. Many strategies do not yield profits, even though they are popular and well-known.
Indicators should be used with caution, and you should practice trading with them using training programs before venturing into the market and using your own money. Various trading simulators available can help you get started; moreover, they can help you determine whether trading based on indicators is suitable for you.
Source: https://www.thebalancemoney.com/what-is-indicator-based-trading-1031212
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