Online Trading: How to Protect Yourself from False Signals

Among the many problems that afflict traders, the issue of false signals stands out. A very important topic that, in some of its aspects, risks questioning the "scientific" or para-scientific nature of online trading. Online traders who operate, or try to operate wisely, consider online trading if not exactly a science, a discipline with statistical evidence. Well, false signals, by effectively refuting the analysis activities, compromise this belief, with all that follows in terms of confidence and, above all, economic losses. In the following article, we offer an overview of false signals, providing some tools to recognize them and offering some advice to defend against them, or at least avoid them.

What are false signals

The term "false signal" refers to evidence determined by analysis activity that, despite good premises, proves to be false. One of the main activities of traders consists of studying the market, or an interpretation work that proceeds from precise tools and equally precise static models. The main tools with which they are realized are indicators and oscillators. Often, however, the analysis is conducted directly on the chart, observing and studying the figures formed by the candles. Well, figures, indicators and oscillators, as well as direct observation of the chart, allow generating signals, or precise indications about the price trend. When the market refutes the signals, we unfortunately speak, in hindsight, of false signals. Avoiding them is fundamental, given the risks they entail (we will talk about it in the next paragraph). Fortunately, it is possible to approach the issue with prudence and by adopting measures aimed at real prevention. The first step is to recognize the situations in which the occurrence of false signals is more likely. Market volatility. One of the reasons why technical analysis can prove fallacious consists in the emergence of external elements capable of depriving the market of its fundamental rationality (e.g. geopolitical events, uncertainty). In that case, the market becomes volatile, and it is very likely that a technical analysis conducted without the necessary precautions can generate false signals. Poor technical analysis. A superficial, coarse, hasty and underdeveloped technical analysis can increase the probability of generating false signals. The reference is, in particular, to the use of a limited number of indicators. In this case, in fact, the burden of "counterevidence" is lacking. Poor or absent fundamental analysis. If it is true that volatility represents an important factor, and that this is often generated by external elements, it is evident that fundamental analysis assumes a crucial role. Those who neglect fundamental analysis fail to understand in time when the market is becoming "insensitive" or partially insensitive to technical analysis. Low level of discretion. Bad forms of automatic trading, i.e. those that give insufficient importance to human intervention, produce signals that could prove to be unreliable. In the worst cases, false signals in a strict sense.

The risks of false signals

From the previous paragraph, we can already grasp how dangerous false signals can be. It is good, however, to list and deepen these risks. Misunderstanding the price direction. A false signal is like a wrong road indication. It convinces the trader that the market is taking a certain direction, while the reality of the facts turns out to be another. Now, it is obvious: if the trader fails to predict with a sufficient degree of approximation the direction of the price, any trade risks failing in the worst way. In a certain sense, false signals make the trader blind or, to put it better, they deceive him. Losing money. This is the most important occurrence, the risk that must always be avoided. Of course, regardless of the success of the trade, good money management can prevent the draining of capital, but a more or less large loss of money, if false signals are heeded, always occurs anyway. After all, if you go short when the market rises or go long when the market falls, the results can only be negative, even if you place a stop loss very close to the price. Losing profit opportunities. False signals can also produce another type of consequence, at first glance less dramatic: the loss of opportunities. The reason is simple: if you wait for a positive trend to enter the market but the signal indicates that the price will fall, the trader simply does not move. If then the signal proves to be false, here materializes the classic missed train. The economic damages, therefore, develop (it is just the case to say it) along two tracks: the concrete loss of money and the loss of opportunities.

The precautions to take

It is good to say it: false signals are the order of the day. The important thing is to recognize them and ignore them. Fortunately, there are fairly effective precautions, especially if enhanced by a high degree of experience. Analyzing the economic context. We mentioned it in the previous paragraphs. False signals in most cases are caused by a condition of inscrutability of the market, often accompanied by a marked volatility. Now, if you remain on the chart, and do not move to the economic-financial environment in general, it is difficult to get to the bottom of it. Above all, it is difficult to recognize the moment as such, that is, as a harbinger of possible false signals. Hence the need to adopt a more extensive outlook and to implement fundamental analysis activities. Analyzing volumes. Fundamental analysis is not enough. Also because a situation of volatility does not necessarily follow false signals. Therefore, it is good to set up a counter-evidence of the signal. How to do? There are more than one method, but the analysis of volume stands out above all. The direction that the signal indicates should always match the volume. If there is a divergence, that is, the signal indicates a trend and the volume indicates another, we could be in the presence of a false signal. Using multiple indicators. The reason is the same: to produce a counter-evidence, to analyze the signal under multiple magnifying lenses. If two or more indicators of the same parameter come to the same conclusion, that is, they produce the same signal, then this signal is reliable. Many indicators, not by chance, are used in pairs. Generally, one indicator is based on moving averages and one on overbought and oversold levels (which depend on volumes). Doing good Money Management. This is a measure that, it is good to specify, does not prevent false signals but simply allows to reduce the nefarious effects. If you adopt solid money management, even if you were to give heed to a false signal, the loss would still be contained, in any case sustainable. Unfortunately, it must be said, some activities related to money management and risk management, such as setting stop losses, can be compromised by false signals themselves.