How to Build a Trading Indicator

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How to Build a Trading Indicator

Elliott and Gann are familiar names in the global trading community. These technical analysis pioneers created some of the most extensively utilized approaches in the profession. But how did Ralph Nelson Elliott and W.D. Gann develop these ideas, and how did they become so popular? To be honest, it’s not as tough as it seems! This article walks you through the process of creating your own custom indicator, which you may utilize to gain a competitive advantage.

Background

Remember that the principle behind technical analysis argues that financial charts take into account everything—that is, all fundamental and environmental aspects. According to the idea, these charts reveal psychological factors that may be understood using technical indicators.

Let’s look at an example to help you understand. Fibonacci retracements are formed from a mathematical series that goes like this: 1, 1, 2, 3, 5, 8, 13, and so on. The current number is the sum of the preceding two numbers, as we can see. What does this got to do with markets? It turns out that these retracement levels (33%, 50%, and 66%) have such a strong impact on traders’ choices that they have established a set of psychological support and resistance levels. The notion is that by locating these spots on charts, one can forecast future price changes.

Components of an Indicator

All indicators are designed to forecast where a price will go when a given situation exists. Traders attempt to forecast two essential things:

  • Support and resistance levels are significant because they are the points at which prices reverse direction.
  • Time is critical because you must be able to foresee when price fluctuations will occur.

Indicators may sometimes anticipate these two aspects directly, like with Bollinger Bands or Elliott’s waves, but indicators usually use a set of principles in order to make a prediction.

When employing the broad thrust indication (shown by a line showing momentum levels), for example, we must know which levels are significant. The indication is little more than a line. The breadth thrust indicator, which is “range-bound” like the RSI, is used to assess the momentum of market moves. There is minimal momentum when the line is in the median zone. When it enters the top zone, we know that momentum has risen, and vice versa. One might consider going long when momentum is rising from low levels and going short when momentum reaches a high level. To make indicators useful, rules must be established to understand the significance of their motions.

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With this in mind, let’s look at several methods for making predictions. Indicators are classified into two types: unique indicators and hybrid indicators. Unique indicators can only be created using core chart analysis components, however hybrid indicators may employ a mix of core elements and existing indications.

Components of Unique Indicators

Indicators that are unique are based on intrinsic elements of charts and mathematical functions. Two of the most prevalent components are as follows:

1. Patterns

Patterns are simple repeated price sequences seen over a specified time period. Many indicators utilize patterns to forecast future price changes. Elliott Wave theory, for example, is founded on the idea that all prices move in a predictable pattern, which is shown in the following example:

Elliot Wave Pattern. Image by Sabrina Jiang © Investopedia2020

Many more basic patterns are used by traders to indicate regions of price movement within cycles. Triangles, wedges, and rectangles are a few examples.

These patterns may be found by merely glancing at charts; however, computers provide a far quicker approach to complete this operation. Such patterns may be found automatically using computer software and services.

2. Mathematical Functions

Price averaging to more complicated functions based on volume and other metrics are examples of mathematical functions. Bollinger Bands, for example, are simply defined percentages above and below a moving average. This mathematical formula generates a visible price channel with levels of support and resistance.

Components of Hybrid Indicators

Hybrid indicators are simple trading methods that employ a mix of current indicators. There are several methods to combine components to create appropriate indications. Here’s an illustration of the MA crossover:

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This hybrid indicator employs a number of indicators, including three occurrences of moving averages. First, the three-, seven-, and twenty-day moving averages must be calculated using the price history. The rule then searches for a crossover to purchase the security or a cross-under to sell it. This approach suggests a price movement level that may be predicted and offers a good estimate of when this will occur (as the lines draw closer together).Here’s how it may look:

A moving average crossover. Image by Sabrina Jiang © Investopedia2020

Creating an Indicator

A trader may develop an indication by doing the following easy steps:

  1. Choose whether you want to create a unique or hybrid indication.
  2. Choose the components that will go into your indication.
  3. Make a set of rules (if required) to regulate when and where price variations may be anticipated.
  4. Backtesting or paper trading your indication in the actual market is a good way to put it through its paces.
  5. Put it to use if it generates excellent results.

An Example

Assume we want to construct an indicator that monitors one of the most fundamental aspects of markets: price swings. Our indicator’s purpose is to forecast future price changes based on this swing pattern.

Step 1:

We want to create a one-of-a-kind indication by combining two key elements: a pattern and math functions.

Step 2:

Looking at weekly charts of business XYZ’s stock, we observe some basic bullish and bearish movements that last roughly five days. Because our indicator is designed to detect price swings, we should be looking for patterns to characterize the swings as well as a mathematical function, price averages, to define the breadth of these swings.

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Step 3:

The rules that govern these components must now be defined. The patterns are simple: they are bullish and bearish patterns that alternate every five days or so. We take a sample of the duration of rising trends and a sample of the length of negative trends to calculate an average. Our final result should be an estimated time frame for these transfers to take place. We utilize a relative high and a relative low to determine the scope of the swings, and we put them at the high and low of the weekly chart. Next, to generate a prediction of the present incline/decline based on previous incline/declines, we simply average the overall incline/decline and forecast the same measured changes (+/-) to occur in the future. The pattern, once again, determines the direction and length of the motion.

Step 4:

We take this method and manually test it, or we utilize software to plot it and generate signals. It can effectively yield 5% each swing, according to our findings (every five days).

Step 5:

Finally, we put this notion into action and trade with actual money.

Bottom Line

Building your own indication entails delving further into technical analysis and then combining these fundamental components to create something unique. Ultimately, the goal is to get a competitive advantage over other traders. Consider Ralph Nelson Elliott or W. D. Gann. Their successful indications provided them with not only a trading advantage, but also reputation and celebrity in financial circles throughout the globe.

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