Many binary options brokers give you the ability to end a trade early at a partial loss. This can be an attractive feature, but it is almost never the correct choice to make. Still, it can be a useful tool once in a while, so it is worth looking at to see if and when […]
Is the Golden Mean a Useful Technical Indicator?
The Golden Mean is one of those numbers that we hear tossed about once in a while in the world of trading, but does this “magical” number actually have any sort of predictive powers when it comes to price changes? We were curious, and after taking a look, decided to share what we found.
eThe Golden Mean is a ratio that often brings about completeness in nature. It has been purported to also bring completeness in other areas of human life, and the financial markets is one of those places. Speaking a little more concretely, the Golden Mean is equal to 1.618 (or 0.618, depending on the direction of movement) and is used in triangular objects. When this number is multiplied by the height of a triangle to calculate the most natural position for the remaining side. Even in nature, this is a pretty loose rule, but it does act as a decent rule of thumb when approximating.
In the Forex market, traders will often establish a triangular pattern on a price chart, find the price level at the widest part of the triangle, and then multiply that price by 1.618 to establish a price target for the future.
To use this number with any hope of success, you need to first have pattern recognition down. A lot of traders use MetaTrader 4 to help themselves here. That’s not cheating. If you are not using MT to help with your Forex trades—even if you don’t trade with a Forex broker but use a binary options broker—you are seriously limiting your capability. MT4 is free to use, and it is pretty easy to get downloaded on your computer. Even if you need to sign up for a demo account with a Forex broker to gain access to this software, it is worth the trouble.
Next, enter a triangle pattern indicator into your software and calculate the wide point on the chart. Depending on the trend of the price, multiply the given number by 1.618 for upward trending charts, or 0.618 for downward trends. The number that you calculate is supposedly the target price for trade outcomes, according to the Golden Mean method.
Simple, right? The big question remains: does it work?
Here’s problem number one. Even those that rely heavily on the Golden Mean readily admit that the application and the results of this tool are open to interpretation. That’s a sure sign of trouble—when you use an indicator, you want to know how to use it. Even the tools that have a lot of flexibility have specific steps that need to be followed when they are being used. For example, when using different exponential moving averages, the goal of the trader is to identify when these lines cross and a change in momentum is acknowledged.
Problem number two is a bit more subtle. Let’s say that you stumble upon a way to successfully use the Golden Mean for a few trades. Great! The next issue that we face is replication. Is the Golden Mean working in your trades because you have found a way to apply it in a way that makes sense? If so, what are the conditions that exist? If your application under similar scenarios is consistent, you would expect a working outcome to be able to return you an overall profit. Otherwise, this is not a pattern that has any sort of tangible evidence that it works. We are at an immediate disadvantage here because of the disagreement in how the triangle pattern should be applied and interpreted.
The final problem with this method is that if it does work, it is likely not transferable and subject to error. This is common for all technical indicators, even those that have proven themselves over the course of many years. The most common example we could point to is that some sort of news event can completely skew your data. Another strong example is that the EUR/GBP doesn’t act like the USD/JPY. What works for one pair is not going to operate the same for another. Even within a static pair, such as the EUR/USD, what worked yesterday might not necessarily work today. The transferability of a technical indicator is what gives it recognition from other traders, and the Golden Mean hasn’t shown that it has this property. When it works, it works under very specific and very difficult to repeat circumstances. And extrapolating those circumstances to a future situation is very hit or miss.
We had no choice but to come to the conclusion that the Golden Mean doesn’t contribute much to the prediction of movement in currency pairs when it comes to binary options or Forex trading. It is a useful strategy only when other traders are simultaneously using it. Unfortunately for fans of this indicator, it does not have the widespread usage that is needed for this strategy to be of any use to the average spot trader or binary options trader.
Of course, this doesn’t mean that it cannot work ever. Even random chance will give you winning trades once in a while. And one solitary study cannot prove that a pattern is useless. In fact, you may have even used this method of trading and found success with it in the past. If you have, we are not trying to discredit your accomplishments. The bottom line for our purposes is that on a large, universal scale, even a proper application of a Golden Mean interpretation against a triangular pattern is at best using abstract past data to predict a precise and concrete future movement.
The best case scenario that you are giving yourself for success is that if this is true, then it acts as a self-fulfilling prophecy and other traders will recognize that when this warning sign occurs, something will happen. If this is the case, then the Golden Mean is probably not the best candidate to use. There are many other more easily recognized and more established patterns that you can use that will accomplish the same thing.
***Your capital may be at risk. This material is not investment advice.***