Every trader thinks the technical indicators she uses are the best for market timing. Such convinced reliance is based on familiarity. When technical indicators are applied clinically, their actual performance is often surprisingly high or low relative to their reputations as excellent indicators. Although technical analysis purists state there should be no human second-guessing of the indicators; in reality, unless a computer is making the trades, human action and reaction do affect performance.
The Human Element
When a trader works exclusively with certain indicators, he knows their strengths and weaknesses within certain market situations and adjusts his actions accordingly. Every indicator occasionally will give a false signal. Experienced traders develop a sense of when technical trading signals can be trusted and when they should be treated skeptically. There seems to be no great truth supporting either the purist approach of computerized trading or the less exacting approach of human instinct. Like playing chess against a computer, sometimes the human wins.
In a 2003 study of the relative performance of 126 different technical indicators, by technical trading guru Robert W. Colby, short-term moving averages came out on top. The Exponential Moving Average (five days) and the Weighted Moving Average (six days) ranked first and second. This is because they represent current market sentiment when they cross a longer-term moving average of 120 days or longer. The 120-day Exponential Moving Average, for example, ranked 42nd in the list. The market will move up and down, but when market sentiment is strong enough to propel a short-term moving average through a longer-term moving average, the market direction is confirmed. A moving average is figured by adding the last five days, six days or 120 days, subtracting the oldest market data and adding the newest, then dividing by the number of days to obtain an average.
Oscillators are similar to moving averages but they have individual quirks. The McClellan Oscillator, one of the best known, derives its signals by subtracting the number of advancing issues in a stock index from the number of declining issues over 39 days and 19 days, then subtracting the 39-day exponential moving average from the 19-day exponential moving average. The McClellan Oscillator and its Summation Index ranked 31st and 32nd in Colby's list. The third-best technical indicator on the list was the Percentage Hughes AD Oscillator. It is figured by subtracting the number of declining issues in an index from the number of advancing issues and dividing by the total number of issues traded on the index that day.
Technical indicators attempt to describe the directional sentiment building in a market index, or the broad market, by using specific combinations of market facts. Many of the most successful indicators and oscillators reflect the number of advancing issues or shares of stock versus the number of declining issues or shares. The simple truth of this type of indicator is that when more people are buying than selling, the market will advance. The converse is also true. Five of the top 10 performers on Colby's list relate advancing market movement to declining movement in some way to obtain a market timing signal.
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