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.

ATR: Reading Volatility

As buyers and sellers pass through the marketplace throughout the course of a trading session, the price charts will simply reflect the behavior of the two opposing forces, and their varying waves of strength and weakness. Like ocean currents, the market will oscillate between relative degrees of volatility and direction. Volatility decreases and trading ranges develop as the market inhales to absorb capital from both buyers and sellers. Eventually price action break's out as the volatility increases, and the market exhales in the direction of least resistance. The ATR (Average True Range) gauges the average range from low to high of each candlestick during its respective period of time. In the first segment of the following chart, we can see a trading range develop as the ATR indicated a decreasing amount of volatility. Eventually as the market became complacent, one side of the market took control; in this case the sellers, as a breakdown occurred to new low prices. Understanding this basic mechanism can help us understand when it is a good time to 'play the range'; as volatility decreases, and 'buy the breakout' as volatility increases.

Change Of Direction And Exhaustion Spikes

We constantly face the question, what ingredients make up a good trade? Entry; the closer that we buy off the bottoms, and sell off the tops, the greater amount of profit we can enjoy, while taking on a smaller amount of risk. Assuming the market establishes a 100-pip trading range between 1.2100 and 1.2200, it clearly makes sense that buying at 1.2110 is a better trade than buying at 1.2150, or 1.2170. However the dilemma we face is as follows: If we continue to buy market bottoms, we run the risk of buying a seemingly never ending downtrend, a practice also known as 'catching a falling knife'. So the $10,000 (demo dollar) question remains how can we buy the bottoms and sell the tops, only when the trend is in the midst of a change in direction? The following chart may help add some light to this predicament.

The following (1-hour) chart shows the GBPUSD breakdown, below it's established up trending channel. We may interpret this as a sign of a change in trend, as the market now shows a greater likelihood to now reverse back to the downside. With this in mind, it clearly makes sense that as we should only look to sell-short as a broken up-trending channel tells us we have a better chance to see lower prices in our near future.

As a general rule of thumb, while buyers try to go long at the lowest possible price, those who wish to sell-short should look to do so at the highest possible level. We can see that after the up-trending trading channel failed to contain the market's price action, a long-candlestick wick popped up above the upper Bollinger Band. In this application, I prefer to set the Bollinger Bands to a 3rd standard deviation as this will help isolate only the extreme market spikes.

To summarize, our goal is to enter the market as it takes its last exhausted attempt at a failing trend. Putting this together, this trade set-up allows us to identify short-term changes in trend, and then enter the market at its relatively extreme price levels. Although this scenario may not 'play-out' as cleanly every single time, it provides us with the criteria to wait for the right trade, and wait for the right price. Best of luck in trading!!!