What Is a False Signal?

In technical analysis, a false signal refers to an indication of future price movements that gives an inaccurate picture of the economic reality. False signals may arise due to a number of factors, including timing lags, irregularities in data sources, smoothing methods, or the algorithm by which the indicator is calculated.

Key Takeaways

  • In technical analysis, a false signal refers to an indication of future price movements that gives an inaccurate picture of the economic reality.
  • False signals may arise due to a number of factors, including timing lags, irregularities in data sources, smoothing methods, or the algorithm by which the indicator is calculated.
  • Since trading on false signals can be extremely costly, trades are only placed when there is a consensus of technical indicators showing a future price movement.

How a False Signal Works

Technicians need to have a thorough understanding of the technical indicators they are using so that they are better able to detect false signals when they arise. Many technicians prefer to use a mix of technical indicators to function as a checking mechanism. Since trading on false signals can be extremely costly, trades are only placed when there is a consensus of technical indicators showing a future price movement.

Special Considerations

Avoiding False Signals

Removing noise from a chart helps traders better identify true elements of a trend. One way traders do this is by averaging candlesticks on a chart. Using only the averages eliminates the intraday fluctuations and short-lived trend changes, creating a clearer image of the overall trend. Other charting methods seek to display only actual trend-changing moves, ignoring all other price data. One such chart is the Renko chart, which accounts for price changes but not time or volume. Canceling all noise, in this case, time, can make applying other indicators for confirmation difficult.

With a Renko chart, a new brick is created when the price moves a specified price amount. Each new block is positioned at a 45-degree angle (up or down) to the prior brick. An up brick is typically colored white or green, while a down brick is typically colored black or red. A brick can be any price size, such a $0.10, $0.50, $5, and so on. Renko charts filter out noise and help traders to more clearly see the trend, since all movements that are smaller than the box size are filtered out.

A better noise-canceling charting method is the Heikin-Ashi chart; it turns simple candlestick charts into those with easy-to-spot trends and changes. Since it still incorporates time, other indicators such as the directional movement index (DMI) and relative strength index (RSI) can be applied. Instead of using the open, high, low, and close like standard candlestick charts, the Heikin-Ashi technique uses a modified formula based on two-period averages. Hollow white (or green) candles with no lower shadows are used to signal a strong uptrend, while filled black (or red) candles with no upper shadow are used to identify a strong downtrend. 

By using multiple indicators and charts that cancel out noise, traders can more effectively spot true signals. When a trader applies multiple indicators to a standard chart and receives one signal from an indicator while the others do not give a signal, the trader can confirm the false identity of the signal by looking to a noise-canceling chart.