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Avoiding False Signals Generated by Indicators

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Avoiding False Signals Generated by Indicators   

While commonly used technical indicators like the MACD and Bollinger Bands have been run through exhaustive tests by traders, it must be remembered that no trading system is perfect 100% of the time.  Essentially what this means is that there will be cases where even reliable indicators like Bollinger Bands and the MACD indicator will generate false signals.  An example of this could be seen if prices failed at the top of a Bollinger Band and then dropped back below the middle Bollinger Band.  In most cases, this would be a signal that traders should take a short position and sell the currency on the expectation that prices will continue lower and drop to the lower Bollinger Band before any rallies are seen.    

But while this might be the case in the majority of instances, there will be a small percentage of the time where the expected follow-through is not seen.  In the hypothetical example above, this could occur if prices dropped below the middle Bollinger Band and then reversed higher, possibly even breaking above the upper Bollinger Band and stopping out the trade at a loss.

MACD Example     

“As an example, a false signal generated by the MACD indicator could be seen,” said Haris Constantinou, markets analyst at TeleTrade, “if a bearish divergence is seen on an hourly chart, with prices making new lows that are not being confirmed by the indicator reading (which would not be making a similar low).”  In these cases, many traders would be looking to establish new buy positions, as forex prices have become very inexpensive on an historical basis and the indicator reading is suggesting that downward momentum is waning.

Again, while this might be the case in the majority of cases (and a rally would likely be seen later), there will be instances where prices will continue to push lower and take traders by surprise.  Eventually, the traders that had established buy positions will be forced to close the trade as their stop loss is hit, and this will result in an unsuccessful trade.  One of the unfortunate aspects of trading is that traders will inevitably experience situations like this, and absorb the losses that are seen after false signals are generated.

Devising Strategies to Limit the Impact of False Signals

While false signals are an unfortunate reality of any trading system (whether it be technical or fundamental in nature), the overall effects of these false signals can be limited.  In fact, even though they can not be eliminated entirely, there are methods that traders commonly employ to decrease the total number of these false signals.  At this point, you might be asking how this is possible, as it almost seems to suggest an ability similar to what is erroneously exhibited by fortune teller or psychics.

 

Ultimately, this is why indicators should be combined and used together, and trades should only be taken when both indicator readings suggest a similar directional path for a currency.  Using two indicators together will help to limit the number of false signals as traders will only listen to and act on signals that agree with one another.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

Posted-In: Markets

 

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