Technical indicators come in two main flavours: leading and lagging.
The leading indicator is the one that nudges the investor to look up at their screens, because something might be about to happen … like when you hear the pitch of the commentator’s voice go up rush back to the TV.
The lagging indicator, on the other hand, tells us that something has already happened … with the assumption that, if it’s already happened, it could well happen again.
It’s easy to see why traders would be drawn to leading indicators, which can give us a heads-up, and get us into trades nice and early. However, both types of indicators are prone to false signals – with leading indicators giving signals to events that just don’t happen, and lagging indicators telling us too late, when the market has already changed direction.
Here’s an example of a moving average crossover – a lagging signal …
The first crossover we get here is a ‘sell’ signal, but by the time we’ve had this signal, the market has moved on and is now establishing an up trend. The moving average indicators eventually catch up with this, giving a buy signal further down the line.
In the next example, we have a leading indicator – Stochastics – giving out two false signals, before successfully getting the reversal on this downtrend …
False signals can be very hard to predict, and cost traders a huge amount of money.
But there are some straightforward ways to limit how often they crop up in our trading, and to mitigate their effects when they do …
1. Get confirmation
I tend to think of lagging indicators as the news … and leading indicators as the speculation. Individually, they can be weak in giving us an idea of what’s going to happen next. But when they are combined, we can start to form a picture of how a scenario might play out.
So, if we get a signal on our lagging indicator … we can look to a leading indicator to give us confirmation.
Here’s an example, showing how a Stochastic indicator is used for confirmation of a moving-average crossover …
Adding an extra indicator like this will filter out some of the weaker signals, but it can’t get rid of false signals altogether.
Many traders will then go on to add a third, or fourth indicator, but the answer may be elsewhere …
2. Be patient
There’s a really simple way to check whether a signal is fake or real … watch it to see.
If you get a bullish signal, and the market goes up … it was real.
If you get a bearish signal, and the market goes down … it was real.
So … how do we use this idea of watching the market to see what happens to actually make some money?
The trick here is to reject the idea that we’re going to get in at the start of a new trend. Instead, we’re accepting that this trend will get started without us, and we’ll be jumping on board a bit later.
Yes, it means we’ll miss out on a chunk of those profits. But it should also mean that we miss out on a chunk of those fake signals too.
In the example below, I’ve added a slow moving average, and will not enter a trade until all three MAs are in alignment …
Another way to get confirmation of a move is to wait for a pullback.
Again, this will involve missing out on a number of moves, but the ones you do access will be significantly stronger …
The trick is to pause following the signal, waiting for the price to retrace to a key level.
In this example, the price breaks support, and then pulls back to test that support level (now resistance), before heading downwards …
But the pullback can also be to test a dynamic area of support or resistance, like this …
Waiting for a retracement has the added bonus that you’ll often achieve a better entry level than you would have if you’d tried to jump in quickly.
3. Prepare for fake signals
So, once you have your strategy, which cleverly combines leading and lagging indicators to give you the perfect signal … and waits for trade confirmation, so you’re really confident that the market is really going to make this move … What next?
The reality is that we’ll STILL get fake signals.
There just is no combination of indicators that can give is the right answer 100% of the time. The real world just isn’t that predictable. (If it was, there wouldn’t be money to make from trading!)
Which brings me to the third and most important way to deal with fake signals … be ready for them.
Every indicator has its weaknesses … whether it’s giving signals too late … or getting stuck in overbought/oversold territory for long periods … flitting about in indecisive markets …
As you trade with an indicator, you’ll very quickly become all too familiar with its weaknesses. And that’s where you need to build in your protection in the form of risk management.
Ask yourself how you can quickly limit the downside of a signal that’s gone awry – without damaging the upside of a positive trade. Perhaps it’s quickly bringing in a trailing stop, or watching for price action that could negate your signal.
I’m a big fan of set-and-forget systems, but sometimes in a bid to be hands-off, we ignore glaring signs that somethings gone wrong with our trade, and all the reasons we got in in the first place are no longer there.
The best trading methods will be brutal in cutting trades that don’t make the mark.
With my Heikin Ashi method, after the first 24 hours of a trade, I will usually drastically tighten in my stop. Yes, this leads to a good number of trades being culled quickly, but it keeps my risk-reward levels in line, so I can cope with the false signals that come along.