How to create a successful signal

If you’re using technical analysis to determine your trades, as most of us do, you’ll need to decide which indicators you’re going to rely on.

Some traders will have an arm-full of technical indicators on their charts … some will just use one.

But the happy medium would be to look to two or three indicators – the first triggers a signal, and the second and third are used to “confirm” that signal.

However – simply opening a manual on technical analysis and picking out two indicators you like the look of – is not the answer.

We’re all individual, and different indicators tend to appeal to us – perhaps some make more “sense” to you than others … perhaps they seem easier to apply … perhaps they are intuitive to you … or perhaps you just like the way they look on your chart!

While there’s a lot to be said for using the indicators that most appeal to you – you’re likely to be much more successful with a signal that you really understand – how you combine those signals shouldn’t be left to chance.

Getting a second opinion

The challenge is to combine indicators in a smart way.

Some indicators deliver very different types of information – and some deliver very similar types of information.

And it’s these similar ones that we should beware of.

While it’s frustrating if your indicators are constantly giving you mixed messages and telling you to sit on your hands when you’re eager to get trading … if they are constantly in agreement, you should probably be more concerned.

Second and third levels of confirmation are there to filter out trades that aren’t up to scratch – if they aren’t filtering out some trades, then they aren’t doing their job.

We add second signals to our trading strategies to confirm that what the first one is telling us is correct – rather like seeking a second opinion from a doctor.

If your trading indicators are always (or almost always) in agreement – chances are that your second signal is merely duplicating the first signal. I.e. You’ve gone back to the same doctor for a second opinion.

Here’s an example of a chart showing RSI, Stochastics, Williams %R and the momentum indicator – all of which are showing very similar information …

However, it’s not always as obvious as this that you’re replicating indicators …

Let’s say that you’ve got a trading system that uses moving average crossovers – perhaps you’ve three of them on your chart. And you want to add an extra filter to avoid the whipsaw trades you’re experiencing …

… MACD looks interesting … or perhaps a Parabolic SAR …

It looks like I’ve got stacks of extra information on my chart … but the problem is that both of these tools are based on the same data that you’re already reading off your moving average lines.

Making friends with your indicators

If you’re selecting your indicators at random, chances are that some of them will be based on the same data – that way, adding a second indicator won’t necessarily be doing the job that’s required of it …

So, how do we avoid falling into this trap?

The first check is to understand a little more about what each indicator does. That way you know what you can expect it to predict – and what its shortcomings are.

I’m not suggesting that you memorize the complicated equations that make up each indicator (hey, that’s what we’ve got computers for!)

But, if you think of trading indicators falling into five main categories, this will simplify the process …

Trend indicators: moving averages, MACD, Parabolic SAR

Volume indicators: Volume Oscillator, Chaikin

Momentum indicators: Momentum, Rate of Change, RSI, Stochastic, Williams %R

Volatility indicators: Bollinger bands, average true range

Cycle indicators: Elliot waves

For quality trading signals, we should avoid focusing on just one of these groups.

However, that doesn’t mean we should avoid having two signals from one group altogether.

For example, a couple of moving averages can compliment each other and give a more balanced signal than only one MA.

Likewise, Stochastics and RSI use much of the same information, but one can be used to balance the other.

What’s important with these is that we remember which ones are giving us similar information …

… ask yourself which are complimenting each other, and which are checking each other?

Here’s an example of a system using two moving averages, and two momentum indicators to good effect …

A successful combination

This system uses two trend indicators: 10MA & 20MA; plus two momentum indicators: RSI and Stochastics.

A Buy trade is triggered when the 10MA crosses above the 20MA, and the RSI is above 50, and the stochastic line (%D, the slower one) is heading upwards, but is not overbought.

A sell trade is triggered when the 10MA crosses below the 20MA, and the RSI is below 50, and the stochastic line is heading downwards, but is not oversold.

While the RSI and Stochastics are based on very similar information, they are being used in slightly different ways.

Over the coming months, I’ll be working through different indicators, explaining the strengths and weaknesses of each. I hope this will help you to hone your own strategies to match your trading style.

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