Using Technical Indicators to Develop Trading Strategies -2

Using Technical Indicators to Develop Strategies

An indicator is not a trading strategy. While an indicator can help traders identify market conditions,
a strategy is a trader's rule book and traders often use multiple indicators to form a trading strategy.
However, different types or categories of indicators—such as one momentum indicator and one
trend indicator—are typically recommended when using more than one indicator in a strategy.

Many different categories of technical charting tools exist today, including trend, volume, volatility,
and momentum indicators.

Using three different indicators of the same type—momentum, for example—results in the multiple
counting of the same information, a statistical term referred to as multicollinearity. Multicollinearity
should be avoided since it produces redundant results and can make other variables appear less
important. Instead, traders should select indicators from different categories. Frequently, one of the
indicators is used to confirm that another indicator is producing an accurate signal.

A moving average strategy, for example, might employ the use of a momentum indicator for
confirmation that the trading signal is valid. Relative strength index (RSI), which compares the
average price change of advancing periods with the average price change of declining periods, is an
example of a momentum indicator.

Like other technical indicators, RSI has user-defined variable inputs, including determining what
levels will represent overbought and oversold conditions. RSI, therefore, can be used to confirm any
signals that the moving average produces. Opposing signals might indicate that the signal is less
reliable and that the trade should be avoided.

Each indicator and indicator combination requires research to determine the most suitable
application given the trader's style and risk tolerance. One advantage of quantifying trading rules
into a strategy is that it allows traders to apply the strategy to historical data to evaluate how the
strategy would have performed in the past, a process known as backtesting. Of course, finding
patterns that existed in the past does not guarantee future results, but it can certainly help in the
development of a profitable trading strategy.

Regardless of which indicators are used, a strategy must identify exactly how the readings will be
interpreted and precisely what action will be taken. Indicators are tools that traders use to develop
strategies; they do not create trading signals on their own. Any ambiguity can lead to trouble (in the
form of trading losses).

Choosing Indicators to Develop a Strategy

The type of indicator a trader uses to develop a strategy depends on what type of strategy the
individual plans on building. This relates to trading style and risk tolerance. A trader who seeks long-
term moves with large profits might focus on a trend-following strategy, and, therefore, utilize a
trend-following indicator such as a moving average. A trader interested in small moves with frequent
small gains might be more interested in a strategy based on volatility. Again, different types of
indicators may be used for confirmation.

Traders do have the option to purchase "black box" trading systems, which are commercially
available proprietary strategies. An advantage to purchasing these black box systems is that all of the
research and backtesting has theoretically been done for the trader; the disadvantage is that the
user is "flying blind" since the methodology is not usually disclosed, and often the user is unable to
make any customizations to reflect their trading style.