What are Technical Indicators?
Indicators, such as moving averages and Bollinger Bands®, are mathematically-based technical analysis tools that traders and investors use to analyze the past and predict future price trends and patterns.
The goal in using indicators is to identify trading opportunities. For example, a moving average crossover often predicts a trend change.In this instance, applying the moving average indicator to a price chart allows traders to identify areas where the trend may change.
A growing number of technical indicators are available for traders to study, including those in the public domain, such as a moving average or the stochastic oscillator, as well as commercially available proprietary indicators. In addition, many traders develop their own unique indicators, sometimes with the assistance of a qualified programmer.
Most indicators have user-defined variables that allow traders to adapt key inputs such as the "look back period" (how much historical data will be used to form the calculations) to suit their needs.
There are different types of indicators including trend, Volume, volatility and momentum indicators.
Strategies
Strategies employ indicators
in an objective manner to determine entry, exit and/or trade management rules.
A strategy is a definitive set of rules that specifies the exact conditions
under which trades will be established, managed and closed.
Strategies typically include
the detailed use of indicators or, more frequently, multiple indicators, to
establish instances where trading activity will occur.
Typically, strategies
include both trade filters and triggers, both of which are often based on
indicators. Trade filters identify the setup conditions; trade triggers identify exactly when a particular action should be
taken.
A trade filter, for example,
might be a price that has closed above its 200-day moving average. This sets
the stage for the trade trigger, which is the actual condition that prompts the
trader to act – AKA, the line in the sand. A trade trigger might be when price
reaches one tick above the bar that breached the 200-day moving average.
To be clear, a
strategy is not simply "Buy when price moves above the moving
average." This is too evasive and does not provide any definitive details
for taking action. Here are examples of some questions that need to be answered
to create an objective strategy:
- What type of moving average
will be used, including length and price point to be used in the
calculation?
- How far above the moving
average does price need to move?
- Should the trade be entered as
soon as price moves a specified distance above the moving average, at the
close of the bar or at the open of the next bar?
- What type of order will be used
to place the trade? Limit? Market?
- How many contracts or shares
will be traded?
- What are the money management
rules?
- What are the exit rules?
All these questions
must be answered to develop a concise set of rules to form a strategy.
An indicator is not a trading strategy. An indicator can help traders identify market conditions; a
strategy is a trader's rulebook: How the indicators are interpreted and applied
in order to make educated guesses about future market activity. Often, traders
will use multiple indicators to form a strategy, though different types of
indicators are recommended when using more than one.
Example :
Example :
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.
Instead, traders should
select indicators from different categories, such as one momentum indicator and
one trend indicator. Frequently, one of the indicators is used for
confirmation; that is, 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. One momentum indicator is the RSI, which
compares the average price change of advancing periods with the average price
change of declining periods. Like other technical indicators, the RSI has
user-defined variable inputs, including determining what levels will represent overbought and oversold conditions.
The 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 with
respect to the trader's style and risk tolerance.
One advantage to 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, this does not guarantee future results, but it can certainly help in the development of a profitable trading strategy.
One advantage to 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, this does not guarantee future results, but it can certainly help in the development of a profitable trading strategy.
Indicators are tools that
traders use to develop strategies; they do not create trading signals on their
own.
Choosing Indicators to Develop a Strategy
What type of indicator a trader uses to develop a strategy depends on what type of strategy he or she intends 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.
The Bottom Line
Indicators alone do
not make trading signals. Each trader must define the exact method in which the
indicators will be used to signal trading opportunities and to develop
strategies. Indicators can certainly be used without being incorporated into a
strategy; however, technical trading strategies usually include at least one
type of indicator. Identifying an absolute set of rules, as with a strategy,
allows traders to backtest to determine the viability of a particular strategy.
It also helps traders understand the mathematical expectancy of the rules, or
how the strategy should perform in the future. This is critical to technical
traders since it helps traders continually evaluate the performance of the
strategy and can help determine if and when it is time to close a position.
