Using Trading Indicators Effectively

By Jean Folger AAA

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

Using Multiple Indicators
Types of Indicators
Technical 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.

Figure 1
Chart created with TradeStation.

Using Complementary Indicators
To 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 Clean
Keeping Charts Clean
Since 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. Most trading 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 Overload
Many 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.

One method of avoiding information overload is to eliminate any extraneous indicators from a workspace; if you're not using it, lose it - this will help cut down on clutter. Traders can also review charts to confirm that they are not being encumbered by multicollinearity; if multiple indicators of the same type are present on the same chart, one or more indicator can be removed. (For related reading, see How Market Psychology Drives Technical Indicators.)

Tips for Organizing
Creating a well organized workspace that uses only relevant analysis tools is a process. The quiver of technical indicators that a trader uses may change from time to time, depending on market conditions, strategies being employed and trading style.

Figure 2
Chart created with TradeStation.

Charts, on the other hand, can be saved once they are set up in a user-friendly manner. It is not necessary to reformat the charts each time the trading platform is closed and reopened (see the trading platform's Help section for directions). Trading symbols can be changed, along with any technical indicators, without disrupting the color scheme and layout of the workspace.

Figure 2 illustrates a well-organized workspace. Considerations for creating easy to read charts and workspaces include:

  • Colors. Colors should be easy to view and provide plenty of contrast so that all data can be readily viewed. In addition, one background color can be used for order entry charts (the chart that is used for trade entry and exits), and a different background color can be used for all other charts of the same symbol. If more than one symbol is being traded, a different background color for each symbol can be used to make it easier to isolate data.
  • Layout. Having more than one monitor is helpful in creating an easy to use workspace. One monitor can be used for order entry while the other can be used for price charts. If the same indicator is used on more than one chart, it is a good idea to place like indicators in the same location on each chart, using the same colors. This makes it easier to find and interpret market activity on separate charts.
  • Sizing and Fonts. Bold and crisp fonts allow traders to read numbers and words with greater ease. Like colors and layout, font style is a preference, and traders can experiment with different styles and sizes to find the combination that creates the most visually pleasing outcome. Once comfortable lettering has been found, the same style and size fonts can be used on all charts to provide continuity.

Optimizing Indicators
User Defined Input Variables
It is up to each trader to decide which technical indicators to use, as well as to determine how best to use the indicators. Most commonly available indicators, such as moving averages and oscillators, allow for an element of customization simply by changing input values, the user-defined variables that modify the behavior of the indicator. Variables such as look-back period or the type of price data used in a calculation, can be altered to give an indicator much different values and point out different market conditions.

Figure 3 shows an example of the types of input variables that can be adjusted to alter an indicator's behavior. (For related reading on moving averages, see 7 Pitfalls Of Moving Averages.)

Figure 3
Chart created with TradeStation.

Optimization
Many of today's advanced trading platforms allow traders to perform optimization studies to determine the input that results in the optimal performance. Traders can enter a range for a specified input, such as a moving average length, for example, and the platform will perform the calculations to find the input that creates the most favorable results. Multivariable optimizations analyze two or more inputs simultaneously to establish what combination of variables lead to the best results. Optimization is an important step in developing an objective strategy that defines trade entry, exit and money management rules.

Over-Optimization
While optimization studies can help traders identify the most profitable inputs, over-optimizing can create a situation where theoretical results look fantastic, but live trading results will suffer because the system has been tweaked to perform well only on a certain, historical data set. While outside the scope of this article, traders who perform optimization studies should be careful to avoid over-optimization by understanding and utilizing proper backtesting and forward testing techniques as part of an overall strategy development process.

The Bottom Line
It's important to note that technical analysis deals in probabilities rather than certainties. There is no combination of indicators that will accurately predict the markets' moves 100% of the time. While too many indicators, or the incorrect use of indicators, can blur a trader's view of the markets, traders who use technical indicators carefully and effectively can more accurately pinpoint high-probability trading set-ups, increasing their odds of success in the markets. (For related reading, see How Market Psychology Drives Technical Indicators.)

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