May 10, 2008

Combining Technical Indicators

We all read and use Technical Indicators to determine Buy points and Sell points on the stock chart. Usually experts recommend that we use at least three separate indicators to decide on the Buy/Sell points. The ideas being that you use independent means (indicators) to arrive at the same conclusion, which means we need to understand what indicators are independent.

That is, if you are using RSI, Stochastics and Oscillators to decide on the Buy/Sell points then you may not be using independent means to conclude on the point. You will have to use indicators that measure different aspects of the stock chart: Price action, Momentum, Volume action, Leading/Lagging Indicators, etc., to arrive at the same conclusion separately.

One way to categorize Technical indicators is into:

  • Trend-following or Lagging – for trending phase
  • Over-bought/oversold studies – for trading phase

Let us see when these indicators make more sense to use them. A stock can go through both trending and trading phases. It is sometimes difficult to determine when a trend will stop and a trading range will begin or when a trading range will stop and a trend will begin. So the first step before using any technical indicator is to determine if a chart is in Trending or in Trading Phase. In the chart below that I borrowed from stockcharts.com, the red circles indicate trading range phases that are interspersed among trending periods.

Sometimes just a visual inspection of chart like the one below can reveal if the security is trending or trading. Other times we can use indicators like ADX (Average Direction Index) to evaluate the strength of the current trend, be it up or down. It's important to determine whether the market is trending or trading (moving sideways), because certain indicators give more useful results depending on the market doing one or the other.

In its simplest form, a security's price can be doing only one of three things: trending up, trending down or trading in a range. An uptrend is established when a security forms a series of higher highs and higher lows. A downtrend is established when a security forms a series of lower lows and lower highs. A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken.

Trend following Indicator or Lagging Indicators:

Indicators such as Moving Averages, DMI (Directional Movement Index, which indicates how much of a trend is there), and to some extent the MACD (moving average convergence-divergence, which indicates a directional change), are ideally suited for markets that have established well-defined trends, but tend to get chopped up in range-bound markets. The trend following indicators will not predict change in trend, but rather follow behind the current trend. Therefore they are best suited for trend identification and trend following purposes, not for prediction.

Over-bought/Oversold Indicators:

On the other hand, overbought/oversold indicators, such as Stochastics, RSI (Relative Strength Index, which smoothes price movement and compares strength of move to trend), Rate of change, Momentum, Line oscillators and %R (compares the close with the highest high) are well suited for markets that are locked in sideways trading ranges or markets locked in up or down channels. They tend to be less reliable when markets enter strong trends either up or down. To combine any or all of these indicators into a successful trading system, you must determine the market stage you're in to know which indicators to use.

Resources on the Internet

With a perspective of what indicators you want to use to in order to determine your Buy points or Sell points, get familiar with technical indicators in each category. There are many excellent resources on the web to read up on each of these indicators separately. I personally like www.stockcharts.com, which provides free charting as well as excellent tutorial on each of the technical indicators. But there are numerous websites that offer good services like: bigcharts.com, incrediblecharts.com, etc.

-Nidhi

related posts:

Combining technical indicators - part 2