Indicators
It is possible to use information from indicators to quantify the direction, strength, and potential of trends. These tools may be applied in a strict, quantitative manner, either singly or in combination with other indicators, or they may be used as discretionary inputs into a more extensive process. In the case of trends, indicators and other tools can be useful because they are sometimes able to filter out noise and to reveal the deeper market structure.
An experienced trader can do this based on the raw patterns of price, but newer traders will often find that an indicator simplifies their task considerably. In addition, experienced traders may still want to use some combination of these tools to aid in scanning many markets quickly for specific trade conditions.
Slope of a Single Moving Average
Moving average models are used in econometrics to analyze and forecast trends. One of the simplest trend indicators used by traders is the slope of a single moving average. The length of the moving average will determine the sensitivity of the average, or, more accurately, the time frame on which it will evaluate trends. For instance, a 10-period moving average will have a lot to say about the trend over the past 10 bars, but is not likely to be relevant to the trend over the past 100 bars. Figure 3.30 shows trend changes marked by the slope of a 50-period simple moving average.
Notice that the average lags the actual trend change in the market, but that many false signals come when the average is flat. Those trades could be eliminated by the creation of an “undefined” zone around the average, but this would also come at the expense of later signals for many valid trend changes.
Other Indicators
There are many trend indicators derived from crossovers of one or more moving averages, and a number of more complex tools are also in common use. The Directional Movement Index (DMI) and the Average Directional Index (ADX) were created by Welles Wilder (1978) to quantify trend direction and strength. Linda Raschke and Laurence Conners (1996) advocate usage of the ADX without the DMI to define the strength of the trend while gauging trend direction from other indicators, and they introduce a number of other refinements to the use of this tool. Other traders will use tools such as the MACD histogram or other momentum indicators to provide indications and warnings of trend change. Last, a number of indicators exist that use more sophisticated math, such as linear regression lines, or that apply digital signal processing tools to price data in order to expose the underlying cycles.
Each of these approaches has its merits, but they also bring dangers. Traders can be seduced by the siren song of finding the perfect indicator, and can spend years searching for the best settings or the best combinations of tools. Many traders will find better
results by learning to read price action and market structure, using simple tools to constrain their actions to the realities of the marketplace, and always remembering that our tools are only tools. Go back through the last several charts, and notice how the trend changes given by each of the following tools usually lags the trend changes that you would have identified by simply reading the emerging price structure in each chart. There is no right or wrong here, but there is also no holy grail.
