Using Technical Indicators to Develop Trading Strategies

Indicators, such as moving averages and Bollinger Bands®, are mathematically-based technical analysis tools that traders and investors use to analyze the past and anticipate future price trends and patterns. Where fundamentalists may track economic data, annual reports, or various other measures of corporate profitability, technical traders rely on charts and indicators to help interpret price moves.

The goal when using indicators is to identify trading opportunities. For example, a moving average crossover often signals an upcoming trend change. In this instance, applying the moving average indicator to a price chart allows traders to identify areas where the trend may run out of gas and change direction, which creates a trading opportunity.

Strategies frequently use technical indicators in an objective manner to determine entry, exit, and/or trade management rules. A strategy specifies the exact conditions under which traders are established—called setups—as well as when positions are adjusted and closed. Strategies typically include the detailed use of indicators (often multiple indicators) to establish instances where the trading activity will occur.

While this article does not focus on any specific trading strategy, it serves as an explanation of how indicators and strategies are different (and how they work together) to help technical analysts identify high-probability trading setups.

Indicators

A growing number of technical indicators are available for traders to study, including those in the public domain, such as a moving average or the stochastic oscillator, as well as commercially available proprietary indicators. In addition, many traders develop their own unique indicators, sometimes with the assistance of a qualified programmer. Most indicators have user-defined variables that allow traders to adapt key inputs such as the "look-back period" (how much historical data will be used to form the calculations) to suit their needs.

A moving average, for example, is simply an average of a security's price over a particular period. The time period is specified in the type of moving average, such as a 50-day or 200-day moving average. The indicator averages the prior 50 or 200 days of price activity, usually using the security's closing price in its calculation (though other price points, such as the open, high, or low, can also be used). The user defines the length of the moving average as well as the price point that will be used in the calculation.

Strategies

A strategy is a set of objective, absolute rules defining when a trader will take action. Strategies typically include trade filters and triggers, both of which are often based on indicators. Trade filters identify the setup conditions; trade triggers identify exactly when a particular action should be taken. A trade filter, for example, might be a price that has closed above its 200-day moving average. This sets the stage for the trade trigger, which is the actual condition that prompts the trader to act. A trade trigger might occur when the price reaches one tick above the bar that breached the 200-day moving average.

A strategy that is too basic—like buying when price moves above the moving average—is usually not viable because a simple rule can be too evasive and does not provide any definitive details for taking action. Here are examples of some questions that need to be answered to create an objective strategy:

• What type of moving average will be used, including length and price point used in the calculation?
• How far above the moving average does the price need to move?
• Should the trade be entered as soon as the price moves a specified distance above the moving average, at the close of the bar, or at the open of the next bar?
• What type of order will be used to place the trade? Limit or market?
• How many contracts or shares will be traded?
• What are the money management rules?
• What are the exit rules?

All of these questions must be answered to develop a concise set of rules to form a strategy.

Using Technical Indicators

An indicator is not a trading strategy. While an indicator can help traders identify market conditions, a strategy is a trader's rule book and traders often use multiple indicators to form a trading strategy. However, different types or categories of indicators—such as one momentum indicator and one trend indicator—are typically recommended when using more than one indicator in a strategy.

Using three different indicators of the same type—momentum, for example—results in the multiple counting of the same information, a statistical term referred to as multicollinearity. Multicollinearity should be avoided since it produces redundant results and can make other variables appear less important. Instead, traders should select indicators from different categories. Frequently, one of the indicators is used to confirm that another indicator is producing an accurate signal.

A moving average strategy, for example, might employ the use of a momentum indicator for confirmation that the trading signal is valid. Relative strength index (RSI), which compares the average price change of advancing periods with the average price change of declining periods, is an example of a momentum indicator.

Like other technical indicators, RSI has user-defined variable inputs, including determining what levels will represent overbought and oversold conditions. RSI, therefore, can be used to confirm any signals that the moving average produces. Opposing signals might indicate that the signal is less reliable and that the trade should be avoided.

Each indicator and indicator combination requires research to determine the most suitable application given the trader's style and risk tolerance. One advantage of quantifying trading rules into a strategy is that it allows traders to apply the strategy to historical data to evaluate how the strategy would have performed in the past, a process known as backtesting. Of course, finding patterns that existed in the past does not guarantee future results, but it can certainly help in the development of a profitable trading strategy.

Regardless of which indicators are used, a strategy must identify exactly how the readings will be interpreted and precisely what action will be taken. Indicators are tools that traders use to develop strategies; they do not create trading signals on their own. Any ambiguity can lead to trouble (in the form of trading losses).

Choosing Indicators to Develop a Strategy

The type of indicator a trader uses to develop a strategy depends on what type of strategy the individual plans on building. This relates to trading style and risk tolerance. A trader who seeks long-term moves with large profits might focus on a trend-following strategy, and, therefore, utilize a trend-following indicator such as a moving average. A trader interested in small moves with frequent small gains might be more interested in a strategy based on volatility. Again, different types of indicators may be used for confirmation.

Traders do have the option to purchase "black box" trading systems, which are commercially available proprietary strategies. An advantage to purchasing these black box systems is that all of the research and backtesting has theoretically been done for the trader; the disadvantage is that the user is "flying blind" since the methodology is not usually disclosed, and often the user is unable to make any customizations to reflect their trading style.

The Bottom Line

Indicators alone do not make trading signals. Each trader must define the exact method in which the indicators will be used to signal trading opportunities and to develop strategies. Indicators can certainly be used without being incorporated into a strategy; however, technical trading strategies usually include at least one type of indicator.

Identifying an absolute set of rules, as with a strategy, allows traders to backtest to determine the viability of a particular strategy. It also helps traders understand the mathematical expectancy of the rules or how the strategy should perform in the future. This is critical to technical traders since it helps to continually evaluate the performance of the strategy and can help determine if and when it is time to close a position.

Traders often talk about a holy grail—the one trading secret that will lead to instant profitability. Unfortunately, there is no perfect strategy that will guarantee success for each investor. Each individual has a unique style, temperament, risk tolerance, and personality. As such, it is up to each trader to learn about the variety of technical analysis tools that are available, research how they perform according to their individual needs, and develop strategies based on the results.

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