Signaling Approach

What Is Signaling Approach?

A signaling approach refers to the reliance on various market signals and patterns as indicators for initiating trades or positions.

Key Takeaways

  • A signaling approach structures investing or trading based on data-driven signals.
  • A signally-driven trade is based on data such as price information or metadata such as insider trading activity.
  • Signaling is used in technical analysis as well as built into algorithmic trading systems.
  • Companies may reveal information about their financial health by issuing dividends, buybacks, or debt.
  • Corporate actions such as insiders selling their shares of stock can also serve as a signal to investors.

Understanding Signaling Approach

Technical analysis is often used to fuel the signaling approach with trades initiated and completed by alerts generated from technical studies on price charts. However, the approach is not limited to technical triggers. Any other form of data, such as market sentiment or macroeconomic data, can also be used.

A signaling approach can be used by traders across any type of securities or assets, provided that they trade with sufficient liquidity, and that prices and other relevant data are regularly published. Many traders rely on technical signals such as price charts and momentum indicators. Others attempt to interpret actions by company insiders and executives, who have access to privileged information about a company's performance.

Technical Analysis Based Signals

Because technical analysis is based on readily available data such as price, volume, volatility, timing, and derivative pricing, market signals that lead to inferences about potential price moves in securities are much easier to define and research.

Trading specialists have identified several metrics that can help anticipate future price movements and market activity. Metrics such as on-balance volume and moving averages can help assess long-term trends without the noise of daily price fluctuations, and momentum indicators such as the MACD and Relative Strength Index can reveal the sentiments of the market as a whole.

Developing a signal approach to trading or investing is the precursor to developing a fully algorithmic or even automated trading system. High-frequency trading (HFT) is one such example. These systems use signals that are generated on the millisecond scale to trade in and out of various positions hundreds to thousands of times a day.

Public companies must reveal insider transactions as part of their public filings. This information can be used by analysts to make inferences about the company's future prospects.

Insider Information as Signals

Watching the activity of insiders at a specific company can also provide insight in the company’s stock price. In general, trading on nonpublic information is illegal. However, insiders at a company should have a much broader and comprehensive knowledge of the business and its outlook which makes their trading activities beneficial to watch for outside investors.

However, there are some insider activities that are public information. Insiders are typically granted stock and stock options. When ownership increases through grants it can be a positive signal for the company. Conversely, insiders are also significant shareholders with substantial capital invested in publicly traded stock. Thus, when insiders are selling high volumes of shares it can be a negative indicator for the stock’s outlook.

For example, consider how the trades of company insiders may be used as a trigger in a signal approach. This would be based on the notion that these insiders possess better knowledge of the business dealings of their respective companies, and may trade in accordance with that knowledge. If such knowledge gave them an advantage over other market participants, then following their trades might make for market-beating returns.

Numerous research papers have been written on the influence of insiders’ share ownership as well as their buying and selling activity, but no conclusive studies show an inherent advantage. However, following the trades of insiders is also broadly known as a signal approach to trading since insiders at companies are known to have greater insight into a company’s business dealings than the market overall.

Dividends as Signals

Another approach uses dividends as a signal for a company's future growth. According to this theory, company executives are more likely to post strong dividends if their company has favorable prospects and reliable cash flows. Historically, dividend increases tend to precede an increase in stock prices. Since a company's dividend history is public knowledge, anyone can use this information to make inferences about the company's financial health.

Dividend signaling is somewhat controversial, but some studies support the theory that dividends anticipate future price growth.

How Do You Identify a Trade Signal?

There are several popular trade signals used to forecast when a security may experience a price gain or fall. Each signaling approach relies upon a different set of investment assumptions, so traders should carefully research and consider which signals they consider to be reliable. Most charting software incorporates the most popular trading signals, automatically alerting the user when certain triggering events occur.

What Is the Best Stock Indicator?

While there is no consensus about the best stock indicator, some are more popular among experienced traders than others. Moving averages are commonly used to compare the long- and short-term trends in an asset's price charts, while indicators like the relative strength index are used to assess momentum. In addition, actions taken by company management such as stock buybacks and dividends can be interpreted as signals for a company's financial health.

What Is the Signaling Theory in Finance?

Signaling theory is the belief that information on a company's financial health is not available to all parties in a market at the same time. Since executives and board members have more information about their company's prospects than the wider public, the decisions they make can reveal information about the company's finances. Dividends or stock buybacks could indicate that a company's management expects future growth, while stock or debt issuances could be less favorable.

Article Sources
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  1. 2IQResearch. "Profiting From Insider Transactions: A Review of the Academic Research." Accessed Jan. 2, 2021.

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