In the October issue of Futures magazine, author Jean Folger discusses an important aspect in selecting two or more indicators when developing a trading system. While I don't recommend simply combining indicators to create a trading system, and I don't think that's what Folger is suggesting either, when there comes a time to introduce two or more technical indicators to a trading system, this is when Folger's advice is relevant. The author highlights a common mistake when selecting two or more indicators that could really hinder the performance of your system. By following Folger's advice you can multiply the effectiveness of your system by selecting two or more indicators when done properly.
Types of Indicators
When it comes to technical indicators we are talking about mathematical formulas that are applied to price or volume. These technical indicators include MACD, Moving Averages, Stochastics, ADX, ATR, CCI, and many others. Folger first organized these indicators into different categories based upon what they are measuring.
- Trend - ADX, Moving Averages, MACD, Parabolic SAE
- Momentum - CCI, RSI, Stochastics
- Volatility - ATR, Bollinger Bands, Standard Deviation
- Volume - Chaikin Oscillator, OBV, Rate of Change
Selecting Two Indicators
When it comes to selecting two indicators the mistake can be from selecting two from the same category. By selecting from the same category you are measuring the same market characteristics (Trend, Momentum, Volatility, or Volume). In this case you're not getting new information about the market. For example, if you select ADX and Moving Average you are simply looking at the trending characteristics of the market. I'm a believer in keeping things simple and if you are introducing two indicators that are telling you the same thing, this is not helpful and it needlessly complicates your trading system. Each indicator should be dedicated to a specific purpose, not telling you the same thing two different ways. The point is to look at different market characteristics to expand your view. This can be done by selecting two indicators from different groups, say from Trend and Momentum. Now you are gathering complementary information about the market and are better prepared to make a decision.
Example
An example strategy will make this concept even more clear. I'll take Folger's lead and create a similar strategy used in the original article. Let's create a simple strategy for the S&P E-mini futures market. We'll use a daily chart just to keep things simple. No slippage or commissions will be deducted. Entry signals will generate with the stochastic indicator move out from its overbought/oversold regions. The system will simply reverse its current position thus, we are always in the market.
- Go Long when the SlowD line crosses above 20
- Go Short when the SlowD line crosses below 80
Below are the results of this strategy.
One Indicator
One Indicator | |
|---|---|
Net Profit | $4,325 |
Profit Factor | 1.03 |
Total Trades | 137 |
%Winners | 58% |
Avg.Trade Net Profit | $31.57 |
Annual Rate of Return | 2.08% |
Sharpe Ratio | 0.06 |
Max Drawdown(Intraday) | $50,325 |
Now let's try a complementary indicator. One technique I would like to utilize a lot is the use of a simple moving average to divide the market into two different regimes: bull market and bear market. Often a 200-period moving average applied to a daily chart will work just fine. However, Folger suggested an SMA crossover method to determine the market regime. A 50-period moving average and a 60-period moving average. If the 50-period SMA is above the 60-period SMA the market is considered in a bullish regime. Otherwise the market is considered in a bearish regime. Let's apply this filter here.
- Go Long when the SlowD line crosses above 20 and within Bull Market
- Go Short when the SlowD line crosses below 80 and within Bear market
With these rules added to our buy condition we have introduced a trend-based filter. This should reduce unproductive trades by only taking trades in the direction of the dominate market regime. As a result this should reduce the total number of trades and increase the profitability of our strategy.
Below are the results of this strategy.
Complementary Indicators
One Indicator | Two Indicators | |
|---|---|---|
Net Profit | $4,325 | $48,275 |
Profit Factor | 1.03 | 1.5 |
Total Trades | 137 | 57 |
%Winners | 58% | 47% |
Avg.Trade Net Profit | $31.57 | $846.93 |
Annual Rate of Return | 2.08% | 10.18% |
Sharpe Ratio | 0.06 | 0.10 |
Max Drawdown(Intraday) | $50,325 | $34,825 |
As you can see using two complementing indicators can really improve the results. Keep this in mind when developing a trading system. The example trading strategy is, of course, not a tradable system. It's only an example of how applying a complementary indicator to filter trades can improve the trading system's performance. I personally use this technique a lot. It really can do wonders for a trading system. You will find below the code used in this article along with a TradeStation workspace.
Hi Jeff,
I read Jeff Augen and another author who suggest that moving averages and other conventional indicators like ADX,rsi, etc are useless nowdays due to high frequency trading led by hedge funds and other institutions. As a result the market becomes a field of volatility and the problem is that most conventional indicators including Bollinger Bands can, t fit or help much an individual investor in this kind of market.
What do u think? Is there any volatility indicator u think, is capable of helping…. I would like to read your research or objective
opinion on that matter.
THANKS
PETE
Pete,
Do you know what HFTs do? Because it isn’t betting on indicators at all. The time frames, signals, and dynamics they operate on are as different as night and day from traditional indicators on daily bars.
Medium frequency may be another thing, but high frequency? Different ballgame.
Pete, I don’t think conventional indicators are useless. I can tell you that there are systems that use conventional indicators that are profitable. You will find several ideas on this website that can lead to profitable trading systems.
the only issue with this particular example is that you can have a regime transition without the stochastic signal. So you are short, the trend changes to bullish but you do not get a reading below 20. You are stuck in your short without a hope to get out.
I would allow shorts in a bear and short covering on a cross above 20 and viceversa in bullish phases and, yet, this would leave the door open to the above problem anyway.
A kind of “fail-safe” model would require that during a transition from bear to bull, a stochastic reading > 80 would trigger a short covering and a reversal to long.
My 2 cents.
Another key point is not to mix an indicator with a trend following set of rules with one used in a mean reverting style. Most indicators can be used in both modes, and it often happens to me.
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