Technical indicators are widely available in the public and commercial domain for traders to study. Many traders go as far as to develop their own unique indicators with the help of programmers.
There are three different types of technical indicators, trend following, momentum, and volatility, that have their separate functions but work in unison. This means that they do not provide conflicting information but instead complement each other.
If you’re wondering how indicators can help formulate your profits, then look no further!
Developing Strategies for Profits
Basic level strategies include filters and triggers, which are often based on indicators. Filters help identify the setup conditions while the triggers narrow down the time in which a particular action needs to be taken. Rudimentary strategies like purchasing when the price moves above the moving average are not viable in the long run.
Some questions need to be pondered over to develop the right strategy for yourself:
- What type of moving average are we using? Does it include the length and price point used in the calculation?
- How far above the moving average is high enough to make a move?
- How specifically does your trade have to be compared to the changes in the moving averages?
- Is there an order to place the trade?
- What are the exit rules?
Answering these questions and more will help you develop your unique formula for trading.
Using the Right Indicators
Indicators are programmed to adapt to user-defined variables to suit the needs of the trader’s requirements. For instance, the on-balance volume formula on LiteForex explains how it can be designed to work in stock markets. With that said, it can be evolved to be successfully functioning in other markets as well.
But taking a step back, let’s see the top three indicators before we can move on to understanding how to use them.
The prices undergo constant fluctuations in the market, and the moving average attempts to smoothen out the wild undulations of the numbers. It takes the average price over a rolling number of periods and results in a smooth line that tracks behind the price bars on the charts.
This indicator is preferred during trend following. The smoothened line helps determine in plain sight if the trend is moving upwards or downwards.
Relative Strength Index
This indicator is an oscillator and displays as an underlay indicator, fluctuating between zero and one hundred. It compares the size of the ‘up moves’ versus the ‘down moves,’ most commonly used for finding overbought and oversold conditions in the market.
On short-time frames, it can be extremely advantageous as the prices can change direction quickly. However, momentum indicators need to be used with caution as they may send false signals of change that may never occur.
Average True Range
This is a single number presented on the chart as an underlay. It tracks how the figure has changed over time, usually over 14 periods. It helps measure the realized volatility, or how often the market has changed over time.
This information is essential for day traders who decide the placement of stop loss and take profit orders. Short-term traders also use it to set clear timeframes for when to sell for the right profit.
Combining the Right Indicators
Combining results from three indicators of the same type will result in multiple counting of the same type. This is referred to as multicollinearity by statisticians. It is better to avoid such redundant results as they make other variables appear less important.
Instead, it is advised to select indicators from different categories, where one can be used to confirm whether the other indicator is producing accurate results.
Keep in mind that your strategy depends on what type of result you seek while trying to use indicators. This extends to trading style and risk tolerance:
- Long-term, large profit traders are advised to focus on a trend-following strategy.
- Short-term, small gains traders are pushed towards focusing on a volatility-based strategy.
That covers the focus points, but combinations require research to determine the optimal application formula for each trader’s style and risk tolerance.
An advantage of quantifying a strategy is it allows traders to backtest – a process where traders use historical data to evaluate how the strategy would have worked in the past, to determine what variable to consider for the future. This gives you the advantage of forecast while trading.
Apart from it all, find the right brokerage, identify securities, track and monitor trades and use additional software tools to maximize performance if necessary.
Identifying the specific combination of indicators and rules will formulate your unique strategy. There is nothing set in stone because every trader is different and wants different things. The experimentation phase comes with its own set of failures, but there is no better way to learn. The process will help you understand the mathematics behind the market and manipulate it for your gains. Good luck!