Indicators- Mathematical Machines


Mathematical Machines

Indicators provide by far the most popular way to trade the markets because they are more intuitive to grasp as compared to reading random price movements for newcomers (and pros too!), although there are few drawbacks. But first, what are Indicators?

  • At their very core, indicators are mathematical equations. If you have painful memories with your high school math, then the below example would help.

  • Example: Let's say I worked at a chocolate factory where the company gave me leftover chocolates after each workday. But the number of chocolates I got was always extra and was random each day. I have a family of five, and I want to give them only one chocolate each day. So how would I decide on how many to distribute and how many to keep in the cupboard?

  • I will decide it by the equation x = c- 5. Where c is the number of chocolates I received, and x is the number of chocolates I kept in the cupboard. The remaining ones were eaten, yum.

  • It was a very trivial example, but the indicators are somewhat like this. Instead of random chocolates, they take price inputs inside (open, high, low, close, volume, or even another indicator, etc. ) and output values. For each indicator, the interpretation of this output value differs.

  • There are hundreds of Technical Indicators, but only a few 10-15 indicators enjoy wider popularity and usage. Among them, there are many categories. These categories include Momentum, Trend, Volume, Volatility, etc. Also, Technical indicators can be divided into two categories: Leading Indicators (their signal comes before the price movement) and Lagging Indicators (their signal comes after the price movement). All types of Indicators and their popular usages would be thoroughly discussed in a separate submodule.

Yes, the Technical Indicators seem fascinating, but they are not the magic pill. There are no magic pills in trading. All indicators give out false signals from time to time, and thus it is prudent to balance them with other criteria. The over-optimization and crowding of indicators is a topic we'll dig deeper into in the later sections. Plus, we’ll also explore how successful traders have used them, or traded without using them at all- it is all about personal taste.