Traders like to make use of indicators in their trading but, oftentimes, they resent the fact that they “lag the market”. This question again came up during last night’s webinar on Moving Averages.
Keep in mind, that all indicators are going to "lag the market" to a greater or lesser degree since they are all based on an average of price action that has already taken place. Moreover, the longer the chart time frame we use or the greater the number of periods analyzed by the indicator, the more of a lag that we will see.
Even though every trader would like to be in on the very first pip of a move, it is fine to miss the initial move that a pair makes in favor of entering a trade that has a greater level of confirmation behind it.
If we are looking to enter a trade at the very first sign that a move may be taking place, we are going to find ourselves entering many trades based on very short term signals and, consequently, we will be basing our trades on what ultimately can turn out to be a "false" entry signal…one based on very little data.
While we will give up some pips at the beginning of the move, the lagging nature of indicators will get us into trades that have a more confirmation behind them.
Let’s take a look at a 4 hour chart of the GBPUSD for our example…
Moving Averages will give an entry signal when the faster MA crosses over the slower MA in the direction of the intended trade. In this case the 20 period is the faster MA and the 50 period is slower MA.
The initial move to the downside begins at 1.6615 but our Moving Average crossover does not signal an entry until about 1.6455…some 160 pips later. This is what is meant by a “lagging indicator”.
Keep in mind however that entering at the crossover provides the trader with additional confirmation that the move may continue. The trader would not have had that confirmation if they entered at the very first indication that this pair was moving down. Now that we have hindsight, it appears obvious. But at the point where the “Downward Move Begins” on the chart, had we entered there the potential for that being a “false” entry would have been very high.
Also, take note that the pair when shorted at the Moving Average entry signal at 1.6615 is still moving down on the chart at 1.5980…a gain of over 600 pips.
This example is by no means meant to indicate that this is the type of gain traders can expect when using Moving Averages and/or waiting for greater confirmation prior to entry. However, waiting for that confirmation, regardless of the indicator being used, can lead to higher probability entries.
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