DEFINITION of 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 even the algorithm by which the indicator is calculated.
BREAKING DOWN False Signal
It is important for technicians 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. Also, 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.
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.
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, or DMI, and relative strength index, or RSI, can be applied. By using multiple indicators and charts that cancel out noise, traders 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.