By Jean Folger

Technical indicators are mathematical calculations based on a trading instrument’s past and current price or volume activity. When used as part of a technical trading strategy, indicators can help traders identify unique opportunities in the markets that could be overlooked by simply viewing a price chart. However, you also can cloud your analysis by tracking too many indicators that measure the same qualities of price and volume.

Here, we will review the different types of technical indicators, demonstrate how to apply complementary technical indicators to enhance a trading strategy and explain the importance of selecting dissimilar indicators to avoid multicollinearity, a condition that results from employing multiple similar component techniques.

Indicator types

Indicators often are divided into four categories based on what each group measures:

Trend indicators measure the direction and strength of a trend and typically use some form of price averaging to establish a baseline. Momentum indicators track the speed at which prices change by comparing prices over time. Volatility indicators provide information about the trading range in a given market and its acceleration and deceleration. Volume indicators represent the amount of trading activity that has occurred and analyze the force behind a price movement.

For the most part, indicators by themselves do not provide trading signals. Instead, each trader must interpret the information to determine trade entries and exits based on his or her own trading logic, style, risk tolerance and even chosen trading instrument. Incorporating different types of indicators into a trading strategy (such as by applying one trend and one momentum indicator) will provide better results than using multiple indicators of the same type.

An important part of using technical indicators is to experiment with innovative ways of applying them to the markets. While technical indicators often have a recommended application, traders are by no means limited to those rules. Traders can rely on their own research and market observations to build a better mousetrap.

Combining indicators

To improve market analysis (and the odds of a successful trading system), traders should use complementary indicators — those that present different views of the market while working collectively to provide meaningful data on which to base trading decisions. Because complementary indicators provide unique — rather than redundant — information, they can be used together to provide confirmation for trading signals.

Each indicator that is used in a trading strategy should serve a distinct purpose and provide a unique perspective of the markets — such as to measure momentum or evaluate the overall trend. Like a so-called elevator speech used to explain a product’s purpose in a succinct, pointed delivery, traders should be able to explain concisely why an indicator is on a chart. Answering two questions is paramount: What is it that makes this indicator an important part of the strategy? What unique information does this indicator provide?

We can compare two trading systems to demonstrate the advantages of using complementary indicators. In the first system, only one technical indicator is used to generate trading signals for a simple stop-and-reverse strategy. For the second system, a complementary indicator is added that provides a filter, or confirmation, for the trades. If the conditions are not met, the trade will not be initiated.

“Simple system” (above) shows the basic stop-and-reverse strategy that uses only a stochastic oscillator (a momentum indicator) with the settings 30 for the length, 3 for the first smoothing input and 3 for the second smoothing input. The strategy enters a long trade when two conditions are met:

• SlowK line crosses over SlowD line
• SlowK line is below the oversold territory of 20

A short trade is entered when:

• SlowK line crosses under SlowD line
• SlowK line is above the overbought zone of 80

Ten years of historical E-mini S&P 500 futures data were included in the test (June 17, 2002 through June 19, 2012). The summary performance report is displayed on the chart. This tells us that the strategy shows a profit factor of 1.50, indicating that this strategy would be profitable. While the results are acceptable, adding a complementary indicator can improve performance.

The system is enhanced using a complementary trend indicator to help determine the direction and strength of the trend. For this, a simple moving average crossover is used with lengths of 50 and 60. This adds one additional condition to trade entries:

• For long trades, the 50-period average must be greater than the 60-period average.
• For short trades, the 50-period average must be less than the 60-period average.

“Trend filter” (below) shows the strategy that uses both the stochastic and moving average indicators. With the addition of the moving average crossover filter, the results are improved significantly. While the percent profitable remains relatively steady, 73.17% for stochastic only vs. 77.42% with the moving average filter, the average trade net profit and other key metrics show noteworthy improvement. By adding a complementary indicator, we are able to refine the strategy’s criteria to create a more profitable system.

Beware multicollinearity

While using multiple indicators in a trading strategy can improve results, using the wrong combination of indicators can hurt a system. Some traders may intentionally apply similar — rather than complementary — indicators with the objective of finding confirmation for a trading signal. The problem with using similar indicators — such as two momentum indicators — is that it really provides no confirmation at all because it produces only duplicate results. The two indicators may appear to confirm one another, but this is only because each is based on the same math.

Multicollinearity is a statistical term that refers to the multiple counting of the same information. It occurs when similar indicators are used at the same time. If highly correlated indicators are used to quantify market activity, the results are less meaningful than if different types of indicators are used as part of a strategy. If all indicators are based on the same closing prices, for example, no new information is produced, and therefore, no true confirmation is provided (see “Replicating efforts”). It is akin to trading similar markets in one sector in a mistaken attempt to diversify your portfolio.

A simple method of determining if indicators measure the same thing about the markets is to review their results on a single chart. If each indicator provides similar signals and they move in the same general manner, they likely are collinear and should not be used together. “Replicating efforts” shows a daily chart of the E-mini S&P 500 with a stochastic oscillator and the Commodity Channel Index (CCI) indicator applied. Both the stochastic and CCI are momentum indicators, and both, for this example, have been set to the same length of 30. We can see from the chart that the indicators produce nearly identical results. Using these two indicators together would be detrimental to a strategy because they produce redundant signals with no true confirmation. A second indicator should not catch the same signals, instead it should reduce the number of signals and confirm the more successful — either by percentage or magnitude — signals of the first indicator.

Traders and investors use technical indicators to evaluate past and current market conditions to predict future price movements. To maximize the odds of success for a trading strategy, it is important that each individual indicator provides a different view, and collectively a comprehensive view, of past and current activity so that traders can build a trading model better equipped to forecast the future ups and downs of market prices.