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Why do indicators not work/work? Why is Forex not truly random?

how do indicators work

Joined Dec 2011 | Status: unknown quantity | 362 Posts

Why do indicators not work / work in Forex? Why is Forex not truly random?

Indicators are probably the most used entry into the forex market by beginners. Whether you can make money with them or not has probably been the most discussed topic in forex overall.

I will go into details on why they do not work and at the same time work in forex. This is highly correlated to the fact that forex is a random market but with flaws.

Forex in general is a random market. The next outcome cannot be predicted / computed in any mathematical correct way. This does not mean we cannot make assumptions on what the next outcome / price will be with a percentage > 50%.

You can view the forex market as a random generator BUT with flaws. People sound in security related fields come over this situation a lot: encryption - your encryption is only as good as your random number generator.

And that is where all - no matter if quant/technical or chart based - strategies attack forex: we know the source of the random generator - the traders / algos. Traders are humans and humans are highly predictable. Humans are more highly flawed than even the most crap random number generator. While trading has shifted over to the algorithmic side those still rely on the same principles as the traders themselves did in the past.

That is how patterns, support / resistance etc form.

On the other side we got the MAs which simply form because of the most general and the most true thing in forex: it trends - which of course also is simply a consequence of the traders / alogs psychology along with factors like the cost of doing business (spread/commission), risk:reward etc.

Here is where indicators come into play: Almost all indicators work on the single fact that forex trends - thus they are based on the mother of all indicators: moving averages. No matter which indicator you choose, no matter how fancy it looks - chance is that at the core of it it is based on moving averages or applies them on top of other calculations which simply represent something about price.

So in theory we got something here.

indicators show us if a currency cross (starts to) "trends" or not. So where did that margin call come from.

The magic keyword is currency _cross_. If you apply _any_ indicator(s) to a single currency cross you have one big flaw: A cross is moved by two currencies. No indicator(s) can reliably predict the movement of a single cross because of this since it is only fed the quotient of two currencies e.g. EUR/USD = all EURx divided by all USDx. Those both currencies in turn are made up of the result of its relation against many other currencies. So if your indicator predicts an upmove in EURUSD it can only do so by analyzing the past values of the quotient and apply (hello moving averages) some calculations on it. Your first signal might be correct because EUR might actually being bought across the board and USD actually being sold across the board. The next time however it could be that USD is being sold heavily in one other USD major and only there! This will move EUR/USD up too because of its USD side. To your indicator this looks exactly the same as the previous move but it is entirely different. As soon as that USD major hits resistance / profit taking (which of course will be the moment you enter the market) whatever chance is that you will get your rear-end handed over to the market. Your are especially in bad luck if EUR is actually bearish and now gets power to the downside because USD strength is coming back from those exits in the USD major.

So if you want to exploit the basic principles of forex you need to apply them to the overall market and not a single cross. No matter if you are talking about indicators, levels, whatever. it only works in case things are correlated. That is not always the case so none of those strategies will reliably work on a single cross. The days where things are correlated make people think they do though + correlations change and are a simple result of money flows which get you back to the fact that indicators only work in the moment the flow is actually happening in your cross.

Hope i could help a few people. Have fun n green pips to the ones that deserve it.

Category: Forex

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