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.
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.
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.
Below are the results of this strategy.
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.
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.
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.
Jeff is the founder of System Trader Success - a website and mission to empowering the retail trader with the proper knowledge and tools to become a profitable trader the world of quantitative/automated trading.
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