Use the Right Technical Tools When You Trade

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Thanks for all the great column topic ideas (and keep them coming). The ones we've gotten so far have all been outstanding, and we're looking forward to working through all the suggestions. With that, today we'll address one of the more common requests we've gotten. This particular question came worded many ways, but in essence, it sounds like many of you are looking for the perfect technical indicator. Believe me, I wish there was one. Unfortunately, it just doesn't work that way. If there was one sure-fire trading system, it would have been discovered a long time ago. The only advice I have for those seeking the proverbial holy grail is to give up that search. Instead, focus your time and energy on understanding the most important lesson in technical analysis and systematic trading.

So what's the most important lesson in technical analysis? For the time being, let's just forget fundamental analysis and news-driven market movement. What I'm talking about today is just pure chart-watching. The most important lesson in technical trading is that there are two basic kinds of markets. The first type of market is a trending market. The second type is a range-bound market. Knowing which type of market you're in at any given time is the secret to successful trading. Why? Because the type of market you're in dictates the type of indicator you use.

Now that we know there are two kinds of markets, let's explore the two basic types of indicators. There are oscillators, and there are momentum indicators. Oscillators are reversal oriented. They are designed to spot points in time when a market is overbought or oversold, and due for a reversal. In other words, they indicate points in time when a market move has probably exhausted itself and is ready to turn the other way. Trend indicators, on the other hand, seek to spot momentum, and are continuation-oriented. Their assumption is that a strong trend will continue, and you should trade with the trend. Have you spotted the disparity already? A trend will either continue, or it will reverse - but it can't do both! By default, when one type of indicator works, the other one will not.

Oscillators are great tools in a range-trading environment, characterized by short-lived swings (sometimes on the order of days) and quick reversals. Which oscillators have we used with success? Stochastics, Wilder's Relative Strength Index (not the 'relative strength' indicator), and Wilder's parabolic SAR. The chart below will graphically show how the stochastics indicator has worked well in a range-trading market. Each time we become stochastically overbought, the NASDAQ went lower. Each time we the composite became stochastically oversold, we bounced higher. The accuracy of the stochastic overbought/oversold signals was uncanny.