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.

TUTORIAL: Economic Indicators

Figure 1: QQQQ with a 20-period moving average.

Source: Chart created with 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. (Dig deeper into moving averages. Read Simple Vs.

Exponential Moving Averages.)

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. (For more, check out Create Your Own

Trading Strategies.)

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.

A moving average, for example, is simply an average of a security's price

over a particular period. The time period is specified in the type of

moving average; for instance, a 50-day moving average. This moving

average will average the prior 50 days of price activity, usually using the

security's closing price in its calculation (though other price points, such

as the open, high or low can be used). The user defines the length of the

moving average as well as the price point that will be used in the

calculation. (To learn more, see our Moving Averages Tutorial.)

Strategies

A strategy is a set of objective, absolute rules defining when a trader will

take action. Typically, strategies include both trade filters and triggers,

both of which are often based on indicators. Trade filters identify the

setup conditions; trade triggers identify exactly when a particular action

should be taken. A trade filter, for example, might be a price that has

closed above its 200-day moving average. This sets the stage for the

trade trigger, which is the actual condition that prompts the trader to act

– AKA, the line in the sand. A trade trigger might be when price reaches

one tick above the bar that breached the 200-day moving average. Figure

2 shows a strategy utilizing a 20-period moving average with

confirmation from the RSI. Trade entries and exits are illustrated with small black

arrows.

Figure 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: Chart created with 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.

Using Technical Indicators to Develop Strategies

An indicator is not a trading strategy. An indicator can help traders

identify market conditions; a strategy is a trader's rulebook: How the

indicators are interpreted and applied in order to make educated guesses

about future market activity. There are many different categories of

technical trading tools, including trend, volume, volatility and momentum

indicators. Often, traders will use multiple indicators to form a strategy,

though different types of indicators are recommended when using more

than one. Using three different indicators of the same type - momentum,

for example - results in the multiple counting of the same information, a

statistical term referred to as multicollinearity. Multicollinearity should

be avoided since it produces redundant results and can make other

variables appear less important. Instead, traders should select indicators

from different categories, such as one momentum indicator and one

trend indicator. Frequently, one of the indicators is used for

confirmation; that is, to confirm that another indicator is producing an

accurate signal. (To learn more, see Regression Basics For Business

Analysis.)

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. (Learn

more about the benefits and drawbacks of backtesting. Read Backtesting

And Forward Testing: The Importance Of Correlation.)

Regardless of which indicators are used, a strategy must identify exactly

how the indicators will be interpreted and precisely what action will be

taken. Indicators are tools that traders use to develop strategies; they do

not create trading signals on their own. Any ambiguity can lead to

trouble.

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 2 shows the four basic categories of technical indicators with

examples of each.

Figure 3: The four basic categories of technical indicators.

Traders do have the option to purchase "black box" trading systems,

which are commercially available proprietary strategies. An advantage to

purchasing these black box systems is that all of the research and

backtesting has theoretically been done for the trader; the disadvantage

is that the user is "flying blind" since the methodology is not usually

disclosed, and often the user is unable to make any customizations to

reflect his or her trading style. (Learn how black-box systems work with

intelligent ETFs in Sharpen Your Portfolio With Intelligent ETFs.)

Conclusion

Indicators alone do not make trading signals. Each trader must define

the exact method in which the indicators will be used to signal trading

opportunities and to develop strategies. Indicators can certainly be used

without being incorporated into a strategy; however, technical trading

strategies usually include at least one type of indicator. Identifying an

absolute set of rules, as with a strategy, allows traders to backtest to

determine the viability of a particular strategy. It also helps traders

understand the mathematical expectancy of the rules, or how the

strategy should perform in the future. This is critical to technical traders

since it helps traders continually evaluate the performance of the

strategy and can help determine if and when it is time to close a position.

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. (For more, check out

Survive The Trading Game.)

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