Does combining indicators improve results?

Some traders seem to believe that if one indicator is useful, more indicators must be even more useful. Fortunately for them, they can quickly add indicators to a chart with a few clicks of their mouse. Unfortunately for the, modern technology allows traders to hide almost all of the useful information in a chart. You might think that’s a bold statement but let’s take a look at an example in the chart below.

This chart includes a variety of indicators and shows Bollinger Bands, Andrews’ Pitchfork, stochastics, RSI and MACD. To analyze the chart, we could say that prices bounced off of the lower line of the Pitchfork which is interpreted as bullish; the most recent closing price is above the moving average which is bullish, but the close is also near the upper Bollinger Band and possibly due for a reversal which would be bearish; the stochastics indicator is bullish based on the most recent crossover while RSI is neutral although it confirms the recent price action and MACD is bearish and has been for several months. If you’re keeping score, we have six indicators on the chart and three are bullish, two are bearish and one is neutral. Because we have so many lines, we can’t really see the recent price action.

Without a clear signal, we could add more indicators or we could stop the madness, take a step back and decide what we actually want the chart to tell us.

Price is the most important part of a chart and of course we want prices to be clear. This means we might want to limit indicators in the price pane. Perhaps a trend line and a moving average can help us identify the direction of the trend. This is a weekly chart so we will add a 26-week MA to the chart and remove everything else for now.

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Now we see that prices are in a trading range and the direction of the trend is sideways rather than up or down. This is where indicators can help, but we need to decide which indicators would be helpful.

Indicators can be classified into broad categories. For individual stocks, we can consider the categories to be trend following and oscillators. To analyze the broad stock market we could add sentiment and breadth indicators. There are also other types of indicators but we can perform a complete analysis by keeping it simple and looking only at trend following indicators and oscillators.

Trend following indicators include moving averages and are relatively straightforward. The moving average will tell us whether the trend is up, down or sideways. If prices are above the moving average, the trend is up. When prices are below the moving average, the trend is down. A sideways trend includes those times when prices are close to the moving average, usually in a relatively narrow range without a clear directional bias.

When the trend is up or down, that’s probably all we need to trade. When the trend is sideways, we want to add an indicator that can help us determine the likely direction of the next trend.

Oscillators are indicators that can help us assess the market action. An oscillator is a technical indicator that moves above and below a center line as it changes over time. In other words, the indicator oscillates around a midpoint. Many of the most popular indicators are oscillators. The relative strength index, or RSI, moves between 0 and 100 and can be said to oscillate around its midpoint at the 50-line. The MACD histogram oscillates above and below zero.

Although each oscillator is calculated with a different formula, many serve the same purpose. RSI, MACD, stochastics and many others are all designed to spot when prices have moved too far, too fast and set up a likely reversal. They generate signals when they reach extreme levels and become overbought when prices have gone up too fast or oversold when prices have fallen too fast. In theory, this should provide us with a signal but in practice, indicators tend to remain overbought and oversold for extended periods of time. This means they can be difficult to interpret.

Because oscillators are calculated in similar manners, they tend to tell us the same information and they simply confirm each other. Because of that, we only really need one on a chart. Which one is really a matter of personal preference. In the chart below, we’ve added stochastics.

The addition of the indicator provides useful information. Stochastics was selected because it provides clear signals with crossovers and the pattern the indicator forms adds information. With RSI, another popular momentum indicator, we get relatively infrequent signals and with only one line we don’t have crossovers. MACD provides both crossovers and information about whether prices are overbought and oversold but is less sensitive to the price action because of the way it is calculated. Limiting the number of indicators applied to a chart forces an evaluation of this type and forces traders to understand what their indicator is telling them and what its advantages are relative to other indicators.

In the chart above, stochastics is bullish based on the crossover signal. The indicator has been tracking the price action without a visible divergence. At times, an indicator will diverge from the price action and provide even more useful information.  A divergence forms when prices reach a new high and the indicator fails to follow or when prices reach a new low and the new indicator remains above its previous low. Technical analysts expect the indicator, which measures momentum, to lead the price action and divergences are important warning signs that a trend reversal is likely.

In the chart above, the moving average is telling us we are in a trading range and stochastics is telling us to expect prices to break out of the trading range to the upside.

Ultimately, we trade price and the conservative trader could wait for the price action to confirm the indicator. In this case, the trader would buy when prices reach a new high. The order to buy would be placed just above the highest high seen on the chart. A stop order could be placed just below the recent low, information that would also be available from the chart.

Even though we have removed most of the indicators from the original chart, we seem to have more useful information and we’re able to create a clear trading strategy with less information.

For traders uncomfortable with a chart like this, they could add a sentiment indicator. This category of indicators assesses trader psychology, attempting to define whether most traders are bullish or bearish. The idea underlying these indicators is that when too many traders are bullish, the market should be expected to decline. This could be because with most traders being bullish, there isn’t much money on the sidelines to push prices higher. When too many traders are bearish, we should expect a rally since, in effect, we are running out sellers since bears have most likely already reduced their market exposure.

A sentiment indicator can inform traders about how aggressive they should be. If most traders are bearish, for example, in the chart above traders would expect a rally and could buy at the market price rather than waiting for the price to reach a new high. A preponderance of bulls confirms the decision to wait for new highs and possibly to use the moving average as a closer stop. We will cover a popular sentiment indicator that could be used for this purpose in a future blog posting.