Forex Trading with Stochastics, RSI, MACD, and other Forex Oscillators do NOT work and WHY.
Most Forex Traders use readily available indicators, mostly Oscillators, because that's all they have! Because EVERY charting program has them (Stochastics, RSI, MACD, and ADX) the assumption is that they WORK. The truth is they SOMETIMES do find profitable trades but most times fail and they usually fail because the signals are TOO EARLY.
In our opinion the only thing worse than losses are losses that WOULD have been profitable if you had waited 5 to 30+ minutes.
This teaches traders that if they JUST HOLD ON the trade will turn around and go their way.
You can probably guess where I'm going with this, I've seen it happen hundreds of times the trader learns this and does HOLD ON and a small 5-12 pip loss turns into a 20-30 pip loss which they feel they can't afford to take so they HOLD ON even longer and guess what price just keeps going against them. Now like a deer in headlights they wait and wait and the pain becomes unbearable and they EXIT with a HUGE LOSS! Guess what almost always happens next? Price reverses and sometimes goes so far that they'd have become profitable if they had waited just a bit longer.
If this first trade didn't wipe out the traders account the NEXT ONE will as they hold on even longer as their pain threshold has been increased (similar to how lifting heavy weights makes you stronger, enduring painful situations does also and you can let the next trade go a bit further against you without this excrutiating pain).
It's human nature to look at charts and see patterns and see all the times the forex indicators DO WORK and project out in their mind how much money they will make trading Forex. You almost have to FORCE YOURSELF to think critically to see all the instances of losses.
This forex article will teach you what these Forex indicators are, how they're calculated and the mathematical reasons WHY they do not work.
Definition of 'Stochastic Oscillator'
A technical momentum oscillator indicator that compares a Forex currency's closing price to its price range over a given time period (usually 14 past bars). This Forex Indicator is calculated with the following formula:
%K = 100[(C - L14)/(H14 - L14)]
C = the most recent closing price.
L14 = the low of the 14 previous trading bars.
H14 = the highest price traded during the same 14-bar period.
%D = 3-period moving average of %K
If you are not very math oriented what this does is show you WHERE price is in relation to the last 14 bars high to low range. If price is near the lows the oscillator will show 20 and below. If price is near the highs it will show 80 and above. Most trading platforms use lines to measure the 20 and 80 levels. When above 80 and the oscillator flips down this is used to indicate a Forex SELL. If price is under 20 and flips up this indicates a Forex BUY.
If you haven't guessed it yet the stochastic oscillator OFTEN shows COUNTER TREND SIGNALS! Looking at the example below you can see all the sells as price is TRENDING UP all of which are losing trades. It also fails to catch TINY pullbacks in the uptrend which is the BASIS of our method of trading and in our opinion the way most professionals trade the markets (same technique but on different time frame charts).
This indicator also has TOO MANY TRADES with 27 showing up on the chart below! Depending on your profit objectives there is around 15 winners which is at 55%. We didn't cherry pick days to show this indicator in its worst light there are days when price goes UP UP UP UP and doesn't reverse and the indicator loses almost every time, loses a fortune actually. This is about the best it can do other than on days where price does NOT TREND and goes up then down then up then down then up then down. The problem with those kinds of days is that on choppy days this indicator does its best but volatility is often lower and price doesn't MOVE ENOUGH to make the profits worth the risk. In other words if you risk 10 pips you should have a good shot at making 15 to 25 pips or more. On choppy sideways days you still risk 10 pips but price may only move 5-10 pips your way. It also is LIKELY to stop you our with a loss before it then does what you think it will do.
Huge Problem : Drop-off Effect
The drop-off effect is the abrupt change in the current value when a significant older value is deleted (dropped) from a fixed-period calculation. In this example we use 14 previous bars. WHEN the next bar forms the 14th bar now becomes the 15th bar and is NOT USED in this calculation. If it was a BIG and significant bar of great range this will dramatically affect the oscillator's value and can give a false trading signal and an unnecessary loss. It is for this reason that we have never used most Forex Oscillators until we came up with our own Perfect Oscillator which we will show later in this article.
Definition of 'RSI Relative Strength Index Oscillator'
A technical momentum oscillator indicator that compares the magnitude of a Forex currency's recent gains to recent losses in an attempt to determine overbought and oversold conditions of that currency. This Forex Indicator is calculated with the following formula:
RSI = 100 - 100/(1 + RS*)
*Where RS = Average of x days' up closes / Average of x days' down closes.
The way most traders use the RSI Oscillator is similar to the Stochastics when it is over the Overbought 70 line and turns down it indicates a SELL. When its under the 30 Oversold line and turns up it gives a BUY.
This forex indicator gives fewer signals than the hyper gyrating of the Stocastics however as you can see it also OFTEN shows COUNTER TREND SIGNALS!
Problems with the RSI : It also suffers from the DROP OFF EFFECT and does not show small TREND TRADING PULLBACK trades which in our opinion are the BEST TRADES, and as you can see also tends to miss the EXTREME highs and lows and the huge reversal moves that often follow an extreme high or low. Notice the high around 10am which it misses this was the biggest move down in over 5 hours and this indicator totally missed it but gave 3 losses proceeding it. This is the kind of thing that teaches traders the bad behavior of holding losses and waiting for an eventual reversal.
Definition of 'MACD Moving Average Convergence Divergence Oscillator'
A trend-following momentum Forex indicator that shows the relationship between two moving averages of price bars. The MACD is calculated by subtracting the 26 bar exponential moving average (EMA) from the 12 bar EMA. A 9 bar EMA of the MACD which is called the "signal line" is also plotted on top of the MACD and serves as a trigger for buy and sell signals. When it crosses from below to above its a buy and from above to below its a sell.
As you can see below this indicator gives a lot of trades and its biggest problem is the LAG often showing buys 5-10 bars too late and often at the END of the move and resulting in an immediate loss. When TRENDS CONTINUE this indicator can work and when moves fail to trend it tends to lose. It suffers far less with the drop off effect as EMA moving averages weight current bars more than older ones but a BIG BAR that falls off the end can still influence it occassionally.
Now that I have showed you what we believe does not CONSISTENTLY WORK for Forex Trading, I'd like to share with you an Oscillator that we believe DOES WORK and why.
Definition of OUR 'Perfect Oscillator'
It statistically measures for EVERY TIME OF THE DAY how far price moves in the past and COMPARES todays movement to the past.
WHY did we name it PERFECT Oscillator?
- It shows REAL OVERBOUGHT and OVERSOLD levels based on past volatility levels for that TIME OF DAY (responsive and dynamic)
- It can also help you catch tiny pullbacks in STRONG TRENDS and give very high probability buy and sell signals.
- NO Drop Off Effect - We do not analyze X bars back only the CURRENT bar and compare the momentum to the past for that time of day thus NO FALSE SIGNALS
- There are times that TRENDS are STRONGER TODAY than in the past and indicator will lead to a possible loss but this knowledge can also lead to future wins since strong trends tend to continue.
In the below example you can see how accurate our 80 Levels Overbought and Oversold areas are. These are areas that are STATISTICALLY HIGHLY LIKELY TO REVERSE PRICE!
Of the 9 examples below price reversed 8 times (88.88% Success). Also as I mentioned above WHEN price DOES NOT REVERSE it tells you something! At 5am when price didn't reverse and went up again you KNEW how strong the market was and could trade more lots on the next pullback and possibly avoid the next sell signal. Price then shot up over 70 pips in the next few hours.
When OTHER OSCILLATOR's FAIL IT TELLS YOU NOTHING!
In ADDITION to the Perfect Oscillator Line we also show the DSP (Digital Signal Processor) based moving average (faster and more accurate) of this indicator and plot bollinger bands of the Perfect Oscillator around it. This gives you OTHER WAYS of spotting Statistically High Probability Pullback Trend Trades.
In the below example at 3:30am price went down and formed a lower low. Using swing analysis this often is an early warning of a FUTURE move down. The perfect trade would be a counter trend trade back up where our perfect oscillator hits the upper bollinger band. In this first sell instance the momentum on the way up was NOT ENOUGH to hit the band but this just shows you how weak the market is. You sell as price starts going down entry around 1.3385 and price falls 25 pips and hits the -80 level which tells you its fallen too far and likely to bounce which it does. PERFECT EXIT of trend trade!
Price then goes up and makes higher highs. If the Perfect Oscillator goes down to the Lower Bollinger Band its a high probability buy but what often happens in strong trends is it returns to the 0 line. (ESPECIALLY at the beginnings of NEW TRENDS!)
The next two trades bounce off of the 0 ZERO LINE and are both successful. As a trend matures its MORE LIKELY to go through the 0 line and hit the bottom bollinger band which the third and fourth trade do. The third one works and fourth one fails.
Our Forex trading philosophy is and has always been TRADE WITH THE TREND UNTIL IT GOES STATISTICALLY TOO FAR then Look for Reversals.
(See our Containment Bands, Range Projection, Trend Reversal indicators for how to KNOW when price is less likely to continue). For this example I'm trying to keep it as simple as possible.
After a decent 30 pip pullback off the highs you can see the perfect oscillator GOES THROUGH its moving average. This is often a great timing tool to get into the next wave up. While price didn't take out the highs and trend further this trade should have resulted in a medium sized profit.
Now that you know what does NOT work watch our video to show in more detail what DOES work.