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.
  • 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 asset or securities provided they trade with sufficient liquidity and prices, or other data, are reliably and regularly published.

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 (or so the logic would go).

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.

Regardless of what kind of information is chosen, traders and investors who rely on a signal approach are best served by doing careful, disciplined, and systematic research to identify probable methods for investing this way.

Signaling Approach Examples

  • 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. 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.
  • 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 by any investor 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. When following insiders there are a few factors to consider. The first is shareholder grants. Insiders are typically granted stock and stock options. Therefore when ownership increases through grants it can be a positive signal for the company. Adversely, 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.