Cryptocurrency trading, or any other trading for that matter, is highly unpredictable. George Soros, the legendary trader and who made $1 billion dollar in a single day on his trade against the GBP, once said:
"The markets generally are unpredictable, so that one has to have different scenarios."
So, it's safe to say that it is crucial to have many well thought out strategies in place to face this unpredictability.
To put such strategies and tactics in place we may have to consider different approaches, or types of analysis.
The two most prominent and effective types of analysis are:
- Fundamental analysis
- Technical analysis
While fundamental analysis can give us the "feel" of what's likely to happen. Technical analysis gives us the numbers. In other words, the practical side of things.
Even technical analysis is comprised of different techniques. Mainly, price action and trading using indicators. Or, a combination of both.
However, we can't cover both in one article. So, let's start with indicators and leave price action for another day. It's not that it doesn't deserve our attention. No. On the contrary. I think that applying price action to trading cryptocurrencies could be very profitable. The proof is that there are people that use it and it's working formidably for them.
I use it too. It's just that I do so in my own way. The way that works for me.
Therefore, our focus today will be on how to properly and effectively use indicators when trading cryptocurrencies.
How to use indicators to maximize profits?
Before choosing which indicators you're going to incorporate into your trading, you have got to go through the process of sifting through and evaluating them.
First, you need a place where you can find a big number of indicators to choose from. A great deal of brokers offer a group of the same most popular indicators, as well as different kinds of indicators. Still, they lack variety.
This is why, the first thing to do is to learn how to trade on a professional platform. Like MT4 or MT5. These platforms will liberate you from the constraint of having to work with only what your broker offers. It will also open your eyes on an ocean of indicators that, perhaps, you didn't even know existed.
There are more than 10,000 indicators. The best place to find a great deal of them is to visit the mql5 Codebase. A wonderful place to test a panoply of indicators.
You'll find free indicators, as well as paid ones. I will not be the one to tell you what you should do. But from my personnel experience of more than 4 years trading cryptocurrencies with a consistent profitable record, I can assure you, there are plenty of excellent free indicators. Enough to keep you busy for the rest of your life. Not kidding here.
Then, once you have access to indicators, you need to start back-testing them. One indicator at a time, of course. Don't judge indicators just by looking at them. Avoid doing this mistake. You could miss out on some really good ones.
Why believe in back-testing?
You don't have to. It's just a school of thought. The school of probability.
While it's true that the forces driving the market are not infinite to say that it's completely random. Their interactions are making the behavior of the market, as a whole, unpredictable.
How many times did you read about some cryptocurrency news that made you believe, for certain, that it will impact the market in some way, just for it to do the complete opposite? I think we both can agree that it happens more often than not.
The only argument I will present in favor of the efficacy of indicators, is that it has proven to work thus far. It's an idea that you should just try to accept, if you intend to invest your time in searching for financial freedom.
We rely on historical data to assess the probability of success of a certain trade. In other words, the future performance of indicators. We can never know for sure. we can only guess. How good is our guess is the only thing that matters.
This is why indicators can only provide us a win-to-loss ratio. For instance, an indicator that can tell winning trades 55% of the times is a good indicator. Because it gives us a 5% edge over the market. And an indicator with a 65%-win rate is an excellent one.
In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.
Peter Lynch
Consequently, it is not necessary to believe in an indicator, as you should've planned for the eventuality of it not working well. For when it happens, you should have a good plan in place to mitigate your losses and come out on top. That's what forward-testing can help you do. It's good enough that it works as long as it works.
How can I back-test my indicators?
There are many ways how traders back-test indicators. However, all of them must answer 4 main questions:
- When to enter a trade?
- What will be your risk tolerance?
- Where will the take-profit level be?
- When is a good time to exit?
These four questions constitute the basis of the algorithm used for trading. The combination of indicators that you're back-testing should answer them one by one, respectively.
What structure should I follow?
To generate entry signals, first you need an indicator as a baseline. This one should indicate the general trend of the market. Then a confirmation indicator that will confirm the general trend by giving signals in the same direction. Of course, not all of those signals will be right. Some of them will be losses.
To reduce the number of wrong signals, you can reinforce the first confirmation indicator with a second confirmation indicator that will eliminate some of the losses.
Next, to determine your risk tolerance, which will help you define your stop-loss and take-profit levels, you can add a volatility indicator. This should be directly related to the risk-reward ratio that you're comfortable with.
After that, there's a last piece that needs to be added to your algorithm for it to be complete. It's an exit indicator that gives you the best possible spots where you can exit your trades.
This brings us to a total of five indicators that will work together to provide you with an edge over the market. When back-testing them, they should give good results individually, as well as when they are in combination with one another.
How much historical data should be taken into consideration when going back in time?
A lot of people on the internet say that you absolutely need to cover at least 100 trades while back-testing. I beg to disagree.
It's true that the more data you go through, the more confident you are in your results. However, Statistics and probability don't work like that. It's not because you're searching for a percentage rate that you need to back-test on 100 different trades.
The only thing that you need to keep in mind in order to consider a good enough chunk of past data, is that you should evaluate the performance of indicators through all the cryptocurrency market phases. How would the indicator react when there's an uptrend, a downtrend, when the price is going sideways, or when it's moving erratically.
To give you a reference, I usually back-test indicators on a period of 3 to 5 years. If an indicator can get me through every market phase on a consistent basis, it's a good indicator.
Conclusion
Finally, I would like to add that developing a probabilistic mindset is crucial to knowing how to work with indicators. By that I mean thinking of all the probable outcomes of your trades and setting up clear and rigorous strategies for each one.
What will I do if my trade goes my way and hit my take-profit? What if it starts going my way but doesn't hit the take-profit price? What if I take a losing trade? How would that impact me? financially and psychologically. What if I start losing, but then it doesn't hit my stop-loss?...
The questions are numerous. However, thinking about them and writing down each one will help you confront your fears and assess your situation objectively. It will also help you set your indicators for the right conditions that allow for optimal trade entries and exits.
