The Objective Filter for an Oscillator
We all know emotion can be the devil in your trading career. Often, it is emotion based decisions that keep people from even having a trading career longer than a few months. While emotion often has you buying signals way after a move higher in price which is likely near resistance which almost ensures a losing trade, there is another culprit that leads to the same losing behavior in trading. It is the misuse of indicators and oscillators.
Understand that the movement in price in any and all free markets is a function of the pure laws and principles of supply and demand. Opportunity exists when this simple and straight forward relationship is out of balance, period. What most people don't understand is that when you ignore a governing dynamic that has been around longer than man has walked the earth, you are almost guaranteed a losing trading strategy. You can spend a lifetime attempting to come up with the perfect set of indicators and oscillators with the perfect set of inputs with hopes of attaining all the worlds' wealth and get nowhere. There is a reason for this which is the one thing you need to know about indicators and oscillators: They have NO IDEA there is an ongoing supply and demand relationship at work every second in every market at every price level. They are simple math calculations derived from price. Most are averages of price which means they lag price. Any indicator that lags price adds risk and decreases profit margins in your trading which is not ideal. Don't get the wrong idea, this is not another article beating up the indicators. My goal is to expose the flaws associated with using them and also show you a very astute way to use them in all your trading.
Moving Averages and Trend Analysis
Above we have a chart with a 20- and 200-period moving average. These are widely used moving averages both in the trading and investing community. Notice the slope of the 20-period MA at the area labeled "B". The slope of the 20-period moving average is down in both cases suggesting a downtrend is underway. During this period however, the low risk/high reward buying opportunity is greatest and right in front of you as "B" is the time price is revisiting the objective demand levels "A".
Those who use a MA as a trend filter would never buy when the trend is "down." This group of illusion-based traders and investors would likely conclude and say; "I don't want to buy now, the MA tells me this is a downtrend." The illusion created by only using a MA to determine trend ensures you will ignore the lowest risk/highest reward opportunity to buy (or sell) each time it is offered. Furthermore, this illusion is likely to encourage a trader to take the opposite action of what the objective information (reality) suggests he or she should do.
Moving Averages lag. They are averages of past data. They can only turn higher after price does. Let's focus in on the 200-day moving average. Specifically, notice the area "B" that is below the 200-day MA in. Most traders and investors either see the 200-day MA on a chart or hear about it from some financial news TV program. They perceive the mighty 200-day MA as some magical line that when crossed suggests some valuable information. As we can see, waiting for prices to rise above the 200-day MA before buying ensures three things. First, risk to buy is high, as one would be buying far from the supply/demand imbalance (our demand level from "A"). Second, profit potential is decreased. Third, those who wait until prices have crossed back above the 200-day MA to buy will likely provide profit for the reality based trader/investor who bought at "B," the low risk/high reward entry area. The objective supply/demand imbalance is at "B," and the 200-day MA has nothing to do with it. When a moving average lines up with true demand or supply, the moving average will appear to work. Believing that the moving average actually has anything to do with a turn in price is an illusion.
Let's now explore reality through the eyes of objective logic. The areas labeled "A" are objective demand (support) price levels. How can I claim they are objective demand price levels? It's simple. While prices are trading sideways, supply and demand are in balance. In both instances, prices rose dramatically from those areas of balance. The only thing that can cause a price rally from an area of "balance" is when the supply and demand equation becomes "out of balance." In other words, there were many more willing and able buyers at "A" than there were sellers. The laws of supply and demand simply tell us this is true.
The areas labeled "B" represent the first time prices revisit these two areas of "imbalance." In other words, prices have declined to an area where we objectively know there are more willing buyers than sellers. "B" is the low risk/high reward opportunity to buy. Buying in these two areas ensures three important musts in trading and investing. First, your protective stop must be as small as it can be which offers a trader proper risk management/position sizing. Second, your profit potential, which is the distance from the entry to the supply area above, is as large as it will ever be for this opportunity. In other words, as price moves higher from the objective demand level, it is moving closer to the supply level (target) above, decreasing your profit potential. Third, the probability of success is highest because supply and demand are out of balance.
The Moving Average Cross