Now on to the good stuff: Just how profitable is each technical indicator on its own?
After all, forex traders don’t include these technical indicators just to make their charts look nicer. Traders are in the business of making money!
If these indicators generate signals that don’t translate into a profitable bottom line over time, then they’re simply not the way to go for your needs!
In order to give y’all a comparison of the effectiveness of each technical indicator, we’ve decided to backtest each of the indicators on their own for the past 5 years.
Backtesting involves retroactively testing the parameters of the indicators against historical price action.
You’ll learn more about this in your future studies. For now, just take a look at the parameters we used for our backtest.
| Indicator | Parameters | Rules |
|---|---|---|
| Bollinger Bands | (30,2,2) | Cover and go long when the daily closing price crosses below the lower band. Cover and go short when the daily closing price crosses above the upper band. |
| MACD | (12,26,9) | Cover and go long when MACD1 (fast) crosses above MACD2 (slow). Cover and go short when MACD1 crosses below MACD2. |
| Parabolic SAR | (.02,.02,.2) | Cover and go long when the daily closing price crosses above ParSAR. Cover and go short when the daily closing price crosses below ParSAR. |
| Stochastic | (14,3,3) | Cover and go long when Stoch % crosses above 20. Cover and go short when Stoch % crosses below 80. |
| RSI | (9) | Cover and go long when RSI crosses above 30. Cover and go short when RSI crosses below 70 |
| Ichimoku Kinko Hyo | (9,26,52,1) | Cover and go long when the conversion line crosses above baseline. Cover and go short when conversion line crosses below base line |
Using these parameters, we tested each of the technical indicators on its own on the daily time frame of EUR/USD over the past 5 years.
We are trading 1 lot (that’s 100,000 units) at a time with no set stop losses or take profit points.
We simply cover and switch position once a new signal appears. This means if we initially had a long position when the indicator told us to sell, we would cover and establish a new short position.
Also, we were assuming we were well capitalized (as suggested in our Leverage lesson) and started with a hypothetical balance of $100,000.
Aside from the actual profit and loss of each strategy, we included total pips gained/lost and the max drawdown.
Again, let us just remind you that we DO NOT SUGGEST trading forex without any stop losses. This is just for illustrative purposes only! Moving on, here are the results of our backtest:
| Strategy | Number of Trades | P/L in Pips | P/L in % | Max Drawdown |
|---|---|---|---|---|
| Buy And Hold | 1 | -3,416.66 | -3.42 | 25.44 |
| Bollinger Bands | 20 | -19,535.97 | -19.54 | 37.99 |
| MACD | 110 | 3,937.67 | 3.94 | 27.55 |
| Parabolic SAR | 128 | -9,746.29 | -9.75 | 21.96 |
| Stochastic | 74 | -20,716.40 | -20.72 | 30.64 |
| RSI | 8 | -18,716.69 | -18.72 | 34.57 |
| Ichimoku Kinko Hyo | 53 | 30,341.22 | 30.34 | 19.51 |
The data showed that over the past 5-years, the indicator that performed the best on its own was the Ichimoku Kinko Hyo indicator.
It generated a total profit of $30,341, or 30.35%. Over 5 years, that gives us an average of just over 6% per year!
Surprisingly, the rest of the technical indicators were a lot less profitable, with the Stochastic indicator showing a return of negative 20.72%.
Furthermore, all of the indicators led to substantial drawdowns of between 20% to 30%.
However, this does not mean that the Ichimoku Kinko Hyo indicator is the best or that technical indicators as a whole are useless. Rather, this just goes to show that they aren’t that useful on their own.
Think of all those martial arts movies you watched growing up. Aside from The Rock and the People’s Elbow, no one relied on just one move to beat all the bad guys. The Rock used a combination of moves to get the job done.
Forex trading is similar. It is an art and as traders, we need to learn how to use and combine the tools at hand in order to come up with a system that works for us.
This brings us to our next lesson: putting all these indicators together!