Using Technical Indicators to Develop Trading Strategies

Moving averages and Bollinger Bands® are mathematically based technical analysis tools that traders and investors use to examine previous market trends and patterns and forecast future price trends and patterns. Whereas fundamentalists may monitor economic statistics, annual reports, or other measures of business profitability, technical traders depend on charts and indicators to help them analyze market movements.

When employing indicators, the purpose is to identify trading opportunities. A moving average crossover, for example, often indicates an impending trend shift. Using the moving average indicator on a price chart in this case helps traders to spot places where the trend may run out of steam and shift direction, creating a trading opportunity.

Strategies commonly use objective technical indicators to define entry, exit, and/or trade management criteria. A strategy defines the precise circumstances under which traders are formed (known as setups), as well as when positions are altered and closed. The comprehensive use of indicators (sometimes many indicators) to define situations where trading activity will occur is characteristic of strategies.

While this article does not concentrate on any one trading technique, it does explain how indicators and tactics vary (and how they function together) to assist technical analysts in identifying high-probability trade situations.

Key Takeaways

• Technical indicators are used to analyze historical patterns and forecast future movements.
• Technical indicators include moving averages, the relative strength index, and stochastic oscillators.
• Trading methods, such as entry, exit, and trade management rules, sometimes rely on one or more indicators to guide day-to-day choices.
• There is no evidence that a single indicator is perfect or the holy grail for traders.
• Strategies (and the indicators utilized within them) will differ based on the investor’s risk tolerance, experience, and goals.

Indicators

Traders may examine an increasing variety of technical indicators, including those in the public domain, such as a moving average or the stochastic oscillator, as well as commercially accessible customized indicators. Furthermore, many traders create their own distinctive indications, often with the help of a competent programmer. Most indicators feature user-defined variables that enable traders to tailor crucial inputs like the “look-back period” (the amount of historical data used to generate the calculations) to their own requirements.

A moving average, for example, is just an average of the price of an asset over a certain time period. The time period is determined by the moving average type, such as 50-day or 200-day moving average. The indicator calculates the security’s closing price by averaging the previous 50 or 200 days of price action (though other price points, such as the open, high, or low, can also be used).The user specifies the moving average’s length as well as the price point utilized in the computation.

Strategies

A strategy is a set of objective, absolute rules that determine when a trader will act. Trade filters and triggers, which are often dependent on indications, are common components of strategies. Trade filters define the setup requirements, while trade triggers specify when a certain action should be executed. A price that has closed above its 200-day moving average, for example, might be used as a trade filter. This lays the groundwork for the trade trigger, which is the actual situation that causes the trader to act. When the price gets one tick above the bar that broke the 200-day moving average, a trade trigger may occur.

A strategy that is too simple, such as purchasing when the price rises over the moving average, is typically ineffective since a simple rule might be too elusive and does not give any solid specifics for action. Here are some examples of questions that must be addressed in order to develop an objective strategy:

• What form of moving average will be employed, as well as its duration and price point?
• How far above the moving average must the price rise?
• Should the trade be entered when the price rises a certain distance above the moving average, at the end of the bar, or at the start of the following bar?
• What sort of order will be utilized to execute the transaction? Market or limit?
• How many contracts or shares are expected to be traded?
• What are the guidelines for money management?
• What are the exit rules?

All of these problems must be addressed in order to create a clear set of principles that will form the basis of a strategy.

Using Technical Indicators

A trading strategy is not based on an indication. While indicators may assist traders in identifying market circumstances, a strategy is a trader’s rule book, and traders often combine indicators to develop a trading method. When employing more than one indication in a strategy, distinct sorts or categories of indicators, such as one momentum indicator and one trend indicator, are often advised.

There are several types of technical charting tools available today, including trend, volume, volatility, and momentum indicators.

Using three separate indicators of the same type—for example, momentum—results in repeated counting of the same data, a statistical concept known as multicollinearity. Multicollinearity should be avoided since it generates duplicate findings and may make other factors look less significant. Rather, traders should choose indicators from several categories. One of the indicators is often used to ensure that another indicator is giving an accurate signal.

A momentum indicator, for example, might be used by a moving average approach to validate that the trading signal is legitimate. A momentum indicator is the relative strength index (RSI), which compares the average price change of advancing periods to the average price change of falling ones.

RSI, like other technical indicators, contains user-defined variable inputs, such as which levels reflect overbought and oversold circumstances. As a result, RSI may be utilized to corroborate any indications produced by the moving average. Contrary signs may imply that the signal is untrustworthy and that the transaction should be avoided.

Each indication and indicator combination necessitates investigation to discover the best application based on the trader’s trading style and risk tolerance. Quantifying trading rules into a strategy has the benefit of allowing traders to apply the approach to historical data to assess how the method would have performed in the past, a process known as backtesting. Finding historical patterns does not guarantee future outcomes, but it may surely aid in the construction of a winning trading strategy.

Whatever indicators are utilized, a plan must specify how the readings will be evaluated and what action will be taken. Indicators are used by traders to establish strategies; they do not generate trading signals on their own. Any uncertainty might cause problems (in the form of trading losses).

Choosing Indicators to Develop a Strategy

The kind of indication a trader employs to design a strategy is determined by the sort of approach the trader intends to build. This has to do with trading style and risk tolerance. A trader who is looking for long-term movements with high gains may use a trend-following strategy and, as a result, a trend-following indicator such as a moving average. A trader who prefers tiny movements with frequent little wins may choose a volatility-based approach. For confirmation, many sorts of indicators may be employed.

Traders may buy “black box” trading systems, which are commercially available proprietary tactics. The benefit of purchasing these black box systems is that all of the research and backtesting has been done for the trader; the disadvantage is that the user is “flying blind” because the methodology is not usually disclosed, and the user is frequently unable to make any customizations to reflect their trading style.

The Bottom Line

Trading signals are not generated just by indicators. Each trader must specify how the indicators will be utilized to detect trading opportunities and construct strategies. Indicators may be utilized without being part of a strategy; however, most technical trading systems contain at least one form of indicator.

Many businesses provide pricey newsletters, trading techniques, or indicators that promise big profits but don’t deliver. Checking reviews and requesting a trial period may assist in identifying dishonest businesses.

Identifying an absolute set of rules, as with a strategy, helps traders to backtest a strategy to verify its feasibility. It also assists traders in comprehending the mathematical predictability of the rules or how the strategy should perform in the future. This is crucial for technical traders since it allows them to continuously review the success of their approach and decide whether or not it is time to exit a position.

Traders often discuss the holy grail—the one trading secret that will lead to rapid success. Unfortunately, no one method can guarantee success for every investment. Each person has an own style, temperament, risk tolerance, and personality. As a consequence, it is up to each trader to learn about the many technical analysis tools available, investigate how they function in relation to their specific demands, and design strategies based on the findings.

Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money.

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