Are There Optimum Indicator Parameters?
A question asked by both professional
and private traders alike
I have been training traders for around 15
years and perhaps the most frequently asked
question of all goes something like: "What
parameters do you use for your moving averages?"
My sincere and honest response is that I
don't use any in my analysis and if I did there
is no such thing as an optimum parameter …
except in hindsight. However, hindsight is not
much worth to us right now.
Is there any such thing as an optimum
parameter for any indicator? Not as far as I am
aware.
Are there any mystical powers about
indicators which make them predict the market?
No.
Let's get this straight. All indicators are
lagging. This is intrinsically so since they are
all calculated from historic prices and there is
categorically no argument to say that price
develops in a linear fashion that implies
indicators can be used to forecast price. I have
not found one that predicts the market.
Let's take an RSI. The default in most
platforms is 14. This is because it was
considered by Welles Wilder who created RSI that
there is a common 28 day cycle in the market and
thus an indicator length of half the cycle
length is a broad yardstick to use.
If you look back at price history and apply
several different length RSIs over that history,
at times you will find that (for example) an 8
period will work well during sharper oscillating
markets while during broad swinging markets a 14
period may work better.
Well, now we have a game plan. We can use an
8 period RSI when the market is choppy and a 14
period when it's not... Now look at your chart
and decide what will happen from now. There is
always an element of judgment involved and no
way of saying for certain which length you
should use.
The next argument is to optimize the RSI and
choose the most profitable periods. Well, it can
be done but having written systems I have never
found a parameter that works without substantial
a drawdown, certainly not one I would care to
trade through. In addition, developing a system
is not as straightforward as it seems. What if
the optimum period is 14 with a profit of 100
but parameters of 12, 13, 15 and 16 only have
profits of 25? (This is not an uncommon
occurrence.) Would you feel confident that the
optimum period was not just an aberration? (In
all probability it is.)
So after all that it seems that there is no
safe parameter to use for indicators. Frankly I
use the default in most cases - at least for
momentum indicators - but the bigger issue here
is not the indicator but how you use it.
Again let's take an RSI. Broadly it is
commonly used as an overbought/oversold
indicator. This is only true during
consolidating markets and not trending. You
should never use these types of signals from
momentum indicators while a trend is in place.
Does this mean it is right that, as soon as RSI
moves above 70 it is time to sell and below 30
is a time to buy?
No. Definitely not… Here is one of the best
bits of advice I can give.
Never take a trade taking a
signal from only one form of analysis.
The biggest piece of the puzzle that many
(and probably most) traders fail to understand
is price. For instance, why take a sell signal
because RSI is above 70 but has not moved back
below a strategic low. It could be beginning an
uptrend and the lows and highs are still moving
higher. It could be pausing in a flag formation
which is a strong continuation pattern. Remember
that many of the best profits come from long
positions when momentum indicators are
overbought (and short positions when momentum
indicators are oversold.)
Always make sure that price is
doing something to confirm your trade…
Maybe you see daily RSI above 70. Fine, move
down into the hourly charts and see if:
- There is a price/momentum divergence, or
- A reversal pattern is developing - then
confirmed, or
- A trend support has been broken.
If any of these occur then your short trade
because daily RSI is overbought stands a much
greater chance of success.
But what has this got to do with the
parameter you choose for the RSI?
Nothing really, but as long as you are using
one that is not an extreme and follows the
market on the majority of occasions the actual
parameter is not important - the combination of
the RSI and price should be enough for the
majority of trades in this way. Just understand
that indicators have their limitations and do
not expect them to magically tell you what trade
to take. Study price. Understand price. Combine
it with indicators and you will have taken a
step forward to better profits |