Many investors and active traders use technical trading indicators to help identify high probability trade entry and exit points. Hundreds of indicators are available on most trading platforms, therefore, it is easy to use too many indicators or to use them inefficiently. This article will explain how to select multiple indicators, how to avoid information overload and how to optimize indicators to most effectively take advantage of these technical analysis tools.
TUTORIAL: Technical Analysis
TUTORIAL: Technical Analysis
Using Multiple IndicatorsTypes of IndicatorsTechnical indicators are mathematical calculations based on a trading instrument's past and current price and/or volume activity. Technical analysts use this information to evaluate historical performance and to predict future prices. Indicators do not specifically provide any buy and sell signals; a trader must interpret the signals to determine trade entry and exit points that conform to his or her own unique trading style. Several different types of indicators exist, including those that interpret trend, momentum, volatility and volume. (For related reading, see The Pioneers Of Technical Analysis.)
Avoiding Redundancy"Multicollinearity" is a statistical term that refers to the multiple counting of the same information. This is a common problem in technical analysis that occurs when the same types of indicators are applied to one chart. The results create redundant signals that can be misleading. Some traders intentionally apply multiple indicators of the same type, in the hopes of finding confirmation for an expected price move. In reality, however, multicollinearity can make other variables appear less important and can make it difficult to accurately evaluate market conditions.
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| Figure 1 |
| Chart created with TradeStation. |
Using Complementary IndicatorsTo avoid the problems associated with multicollinearity, traders should select indicators that work well with, or complement, each other without providing redundant results. This can be achieved by applying different types of indicators to a chart. A trader could use one momentum and one trend indicator; for example, a Stochastic oscillator (a momentum indicator) and an Average Directional Index (ADX; a trend indicator). Figure 1 shows a chart with both of these indicators applied. Note how the indicators provide different information. Since each provides a different interpretation of market conditions, one may be used to confirm the other. (For related reading on the Stochastic oscillator, see Stochastics: An Accurate Buy And Sell Indicator.)
Keep Trading Charts CleanKeeping Charts CleanSince a trader's charting platform is his or her portal to the markets, it is important that the charts enhance, and not hinder, a trader's market analysis. Easy to read charts and workspaces (the entire screen, including charts, news feeds, order entry windows, etc.,) can improve a trader's situational awareness, allowing the trader to rapidly decipher and respond to market activity. Mosttrading platforms allow for a great degree of customization regarding chart color and design, from the background color and the style and color of a moving average, to the size, color and font of the words that appear on the chart. Setting up clean and visually appealing charts and workspaces helps traders use indicators effectively.
Information OverloadMany of today's traders use multiple monitors in order to display several charts and order entry windows. Even if six monitors are used, it should not be considered a green light to devote every square inch of screen space to technical indicators. Information overload occurs when a trader attempts to interpret so much data that all of it essentially becomes lost. Some people refer to this as analysis paralysis; if too much information is presented, the trader will likely be left unable to respond.
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