How To Benefit From Linear Indicators
4 Ways To Increase Your Profits

© By: Ned Gandevani, Ph.D.  Copyright 2004

      In this article, I discuss four ways that you could benefit more from using your favorite linear indicators. By following my methods you could increase your profits and enhance your trading performance.

      Look around and you’ll see hundreds of linear indicators that strive to capture market turning points, highs or lows and so on. The most popular of these indicators are packaged almost in all of the charting and trading programs. Some of these indicators are moving averages (different types), MACD, Stochastics and so on. However, one major problem with these indicators is that they are lagging. They provide information about market behavior that you already know. A moving average tells that market is moving up; well we don’t need any indicator to realize that market is moving up. By mere look at the market we could see that. Another problem with these types of indicators is that they are based on past behavior of the market and expect market to repeat exact behavior in a static format. Market is a non-linear dynamic system and behaves under the influence of its internal dynamics. To assume that market would repeat its past behavior in a static format is like expecting a grown-up individual to act and behave like his teen years or childhood. According to Chaos Theory, dynamic systems exhibit behavioral patterns (i.e. cyclical) only in dynamic fashion. However, you could benefit from linear indicators when using it in a proper manner.

      Before I proceed any further, it’s imperative to note two important rules for maximizing your trading performance with any type of linear indicators. They are;

1. Know State of the Market - In general linear indicators are designed for two types of market, trending and trading. In trending market, you should use an indicator that strives to signal market direction and trend which by definition doesn’t attempt to pinpoint any turning points. If you have identified or convinced that market at the time that you trade is in a trending state, then you should focus your attention on indicators which are designed for that type of markets. As an example any form of moving averages is for trending markets. However, if you believe that market is range bound and trading in a range, then you may use any type of oscillators like RSI, Stochastic, and so on.

2. Longer Time Rules – To avoid noise and price gyrations of any indicators, you may wish to use longer time frame along with your shorter time indicators. For example if your system is a trend following system and tries to profit from market trends, you may use a longer time period for your moving average variable. According to my studies, market has a higher tendency to stay in a trend for about 100-120 days. Therefore, if you are a position trader and follow the market according to your system, you may not wish to use a 5-day moving average to set your trailing stop or exit your trades. In short any action you wish to take based on a short term indicator should be done in accordance with your longer time frame indicator. In other words your longer time frame should precede your shorter one.

      In the following sections, I discuss four effective ways to use your favorite linear indictors for better performance.

1. Entry Confirmation

     To use a single or multiple indicators to generate an entry signal most probably would result in disaster for your trading account and may drain your pocket. Just remember that most of the indicators would provide the same information, just in different names, shapes, and colors. Therefore, to use few of them would not give you any edge whatsoever. However, if you have designed your trading system based on some valid theory and through your research you are confident about its robust performance, then you may use one of your favorite indicators to confirm your entry points. For example if your system has identified a buy signal at 1122.00 in the S&P market and you see that your favorite indicator shows a buy condition, then you could go ahead and buy the market. What you are doing is using a linear indicator to confirm your entry points. Of course you should take into consideration the nature of your trading system. If it is a system for trending market, then use only trending indicators such as moving averages. However, if your system has been designed based on countertrend principles which tries to identify the truing points in the market, then you may be better off to use trading market indicators like MACD or Stochastic. The following chart illustrates how we use the RSI to confirm our system entry.

      In the following chart, Figure 1, our system provides a buy signal at 1122.00. One could use a limit order to enter the market. However, since we do not know what type of external factors may influence the market at that time, we would rather place a market order as our buy price is hit. Certainly, we don’t wish to buy the market when it’s tanking due to release of some economic news. For that matter, we could use RSI to confirm our entry and buy the market at a better price. See that RSI just issued a buy signal which coincides with our system buy signal. Therefore, this would be a good time to buy the market.

Figure 1 – Using RSI, a linear indicator to confirm system’s buy signal.


2. Exit Confirmation

     You could also use any proper indicator to confirm your exit. Suppose your trading system is projecting an initial target for your long trade at 1140.00 to be 1148.00 in the S&P market. As you are following the market you could see that the two-moving averages indicator that you are using has not crossed (the fast one under the slow one). This may indicate that there is more possible room for the market to go up. Market surpasses your second profit target, but the fast moving average has not crossed below the slow one yet. If you were not using this indicator, you might have exited at about 1148 or 1151.50. However, you are able to exit your long trade at the close for a much higher profit at about 1154.00. The following chart in the Figure 2 exhibits how we have used the two moving average indicator to confirm our exit.




Figure 2 – Using two-moving averages, a linear indicator to confirm system’s trade exit.



3. Trailing Stops

     Another way that you could benefit from any of the linear indicators is to manage your trade by using trailing stops for a higher possible profit. We use trailing stops to lock our trade profits for a possible market move against our positions. Suppose you are short from 1154.00 in the S&P futures market. Market sold off and closed just about 1142.00. A prudent trade management method would be to lock your profit in case market goes up fast against your profitable position. To do that, you may move down your protective buy stop according to the bumps that your two-moving averages provide. Anytime, say fast moving average crosses above the slow one; you could trail and move down your stop to that area. You may use any of your favorite indicators to trail your stop. The example depicted on Figure 3 utilizes simple two-moving averages for trailing stops. As shown in that figure we sold the market about 1154.00 then as our indicator created a cross over or a bump at about 1150.50, we trailed our stop to 1151.20, to protect our profits from 1154.00. Then as the indicator created another bump, we moved our stop down to 1148.70. Finally, when our two-moving averages indicator generated another bump, we moved down our trailing stop to 1145.20 and later on got stopped out at 1145.20. By utilizing a simple linear indicator we were able to lock our profit from 1154.00 and manage our trade based on market behavior and not a pre-determined exit price. A common mistake that traders make is they exit their trades rather fast. However, using this method should help you capture a better profit for your positions.

Figure 3 – Using two-moving averages, a linear indicator to trail your stops.


4. Diversion

     One of the better ways to utilize linear indicators is diversion. Diversion means two indicators that are supposed to provide the same information but behave differently. You could use diversion in many different ways, including creating a trading system. For example you could use the diversion between Slow Stochastic and MACD to generate entry signal. Then by using money management method like two points stop or some arbitrary number of points for profit, you have a trading system for you. I have seen, some system which sell for about $4000 that have been developed based on this idea. Well you don’t need to pay such a high price for a system that you could develop it easily with your charting program or Trade Station. Just plug in the two above-mentioned indicators and set your protective stop for two points and your profits for two points and you saved $4000. Of course, I’m not sure if the mere mathematics of that system would ever work for you. However, you may prefer to use the diversion concept to generate entry or exit signal or to confirm your system entry and exit. You may use this powerful concept to manage your trade. Figure 5 depicts an example which utilizes the diversion between price action and RSI reading. Note that at time of short signal, the price moved up but RSI failed to do so.



Figure 4 – Using diversion between price action and a linear indicator, RSI to generate an entry signal.

     I’ll elaborate the diversion theory and concept in future articles. But for now, suffice it to say that you could use this concept to enhance your trading performance.

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