Indicators, such as moving averages and Bollinger Bands, are mathematically-based technical analysis tools that traders and investors use to analyze the past and predict future price trends and patterns. Where fundamentalists may track economic reports and annual reports, technical traders rely on indicators to help interpret the market. The goal in using indicators is to identify trading opportunities. For example, a moving average crossover often predicts a trend change. In this instance, applying the moving average indicator to a price chart allows traders to identify areas where the trend may change. Figure 1 shows an example of a price chart with a 20-period moving average.
Fig1: QQQQ with a 20-period moving average. Source: TradeStation.
Strategies, on the other hand, frequently employ indicators in an objective manner to determine entry, exit and/or trade management rules. A strategy is a definitive set of rules that specifies the exact conditions under which trades will be established, managed and closed. Strategies typically include the detailed use of indicators or, more frequently, multiple indicators, to establish instances where trading activity will occur.
While this article does not focus on any specific trading strategies, it serves as an explanation of how indicators and strategies are different, and how they work together to help technical analysts pinpoint 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 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.
Fig 2: This chart of QQQQ shows trades generated by a strategy based on a 20-period moving average. A ‘buy’ signal occurs at the open of the next bar after price has closed above the moving average. The strategy uses a profit target for the exit. Source: TradeStation.
To be clear, a strategy is not simply “Buy when price moves above the moving average.” This is 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 to be used in the calculation?
- How far above the moving average does price need to move?
- Should the trade be entered as soon as 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? 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.
A moving average strategy, for example, might employ the use of a momentum indicator for confirmation that the trading signal is valid. One momentum indicator is the Relative Strength Index (RSI) which compares the average price change of advancing periods with the average price change of declining periods. Like other technical indicators, the RSI has user-defined variable inputs, including determining what levels will represent overbought and oversold conditions. The 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 with respect to the trader’s style and risk tolerance. One advantage to 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, this does not guarantee future results, but it can certainly help in the development of a profitable trading strategy.
Choosing Indicators to Develop a Strategy What type of indicator a trader uses to develop a strategy depends on what type of strategy he or she intends 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. Figure 3 shows the four basic categories of technical indicators with examples of each.
Fig 3: The four basic categories of technical indicators.
Traders often talk about the 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 trader 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.
Jean Folger can be contacted at PowerZoneTrading