One of the first things traders should decide upon starting is what technical indicators to use to power their strategies. However, choosing between the hundreds of available options and thousands of possible combinations can be tricky. In the process, traders can often end up adding similar trading indicators. Doing so risks significantly reducing the performance of their strategies. This guide focuses on one of the most common mistakes technical traders make. It explains in detail how to avoid using similar technical analysis indicators.
Before discussing how to avoid using similar technical analysis indicators, we should say a few words about the different types of tools you can use.
There are lots of different interpretations of technical trading indicator classification. However, the most accurate is to divide them into two groups. The first is based on their nature. The second is based on the subject of their analysis. Based on their nature, indicators fall into two categories – leading and lagging.
As their name suggests, leading indicators help you predict future price movements. Alternatively, they try to forecast the next price move by looking into historical data. Because of their predictive power, traders often use these indicators to identify potential price reversals ahead of time. Lagging indicators, on the other hand, follow the price.Their signals come after the price has already changed. They help traders confirm the signals from other indicators.
Based on the subject of their analysis, trading indicators are usually divided into four main categories. These are volume, trend, momentum, and volatility indicators.
Volume indicators measure the dynamics in the trading volume for a particular asset and the buying and selling activity.
Trend indicators help determine the price direction based on historical data and generate buying and selling signals.
Momentum indicators help traders evaluate the trend’s strength and predict whether it will reverse or continue its movement.
Volatility indicators analyze the price changes within a certain period to help traders evaluate the state of the market.
Why Should You Avoid Using Similar Technical Analysis Indicators?
Now that you know how to differentiate the different groups of technical indicators, it’s time to focus on what risks the usage of similar indicators bears for your trading strategy performance.
The idea of using different technical indicators is to track various aspects of the price action and get signals that complement each other. If you combine indicators from a similar type or category, you will miss out on getting more complete price action signals.
Furthermore, you will experience the so-called “multicollinearity” issue. Multicollinearity is a statistical term used to describe different ways to derive the same information. In simple terms, you will be using redundant indicators.
In reality, multicollinearity can make other variables appear less important and make it more challenging to evaluate market conditions accurately.
This is a widespread problem in technical analysis, especially when it comes to beginner traders. For example, they often use three or four indicators, hoping to get comprehensive and accurate signals and more decisive confirmation of the expected price move.
However, if these indicators are redundant, the only things they will achieve are firstly a significant complication of the chart. More importantly, they get misleading signals. Doing so makes reading it way more challenging.
How to Avoid Using Similar Technical Analysis Indicators?
There are several ways to ensure you aren‘t using similar technical analysis indicators. Here are the three most important principles to keep in mind:
1) Use Only Complementary Indicators
A well-performing technical trading strategy will give you a timely signal and then confirm or reject it – nothing more, nothing less. So, when building your trading strategy, pick indicators that help you in that sense.
Also, choose tools that work well together and complement each other’s signals without providing redundant or, more importantly, misleading results.
To do that, combine indicators from different categories. For example, make sure to pick a leading and a lagging indicator. A popular combination is the Moving Average Convergence Divergence (MACD) as a lagging indicator and Bollinger Bands as a leading one. Combining leading and lagging indicators will give you heads-up information and then confirm/reject the signal.
Also, combine indicators from different categories based on their subject of analysis. For example – you can use the Bollinger Bands as a volatility indicator alongside the Stochastic Oscillator as your momentum indicator.
Combining indicators that work together (leading + lagging or from different categories based on the aspects that they measure) will give you a broader and more accurate view of the market. It will guarantee a more precise interpretation of market conditions and greater confidence that what you see is what really happens.
An important thing to note is that some indicators can measure more than a single aspect of the price based on how they are applied. For example, the Average Directional Index (ADX) can serve as a trend and momentum indicator. However, the efficiency of such multi-category indicators isn’t the same across the different aspects of the price action they measure. Make sure to learn what each indicator is best for to make the most out of it and avoid redundant signals.
2) Strive to Keep Your Charts Clean
With technical trading indicators, less is more. If you follow this principle, you will start focusing on the essentials and cleaning up your charts. Slowly but surely, you will build the habit of using only the most critical tools for your strategy. For example, having the price action chart, entry windows, volume trackers, news, and two or three indicators maximum is a good start.
Aside from being a natural way to avoid using similar indicators, this is also a critical moment for time-sensitive traders. Those market participants must always be aware of what is going on on their charts and rapidly respond to the events unfolding in front of their eyes.
Having to track two or three indicators is a guaranteed way to keep yourself focused and concentrated on their signals. This will improve your reaction time and help timely capture arising opportunities.
Furthermore, the more indicators you have, the bigger the chance for them to be redundant and the harder it is to gather and interpret their signals.
Bear in mind that your charting platform is your portal to the market. You should make it as comfortable as possible. Make sure to ask yourself whether every element or tool you have on your screen is actually critical for enhancing your performance. Find out if some of these elements aren’t, in fact, hindering your market analysis capabilities since this is often the case when using too complex charts.
Also, experiment with the customization capabilities of the charting platform and choose the best colors and styles to fit your preferences and ease your user experience.
3) Backtest, Backtest and… Backtest
Studying the theory behind different technical trading indicators is a solid foundation for avoiding indicator redundancy.
However, the easiest and most efficient way to ensure you aren’t using similar indicators is by testing different combinations in a demo account. That way, you can find out if the tools you have chosen complement or hinder each other and whether they maximize your strategy’s potential.
For example, if you have ended up using indicators that give misleading signals, you will be able to fix it without risking your capital.
Make sure to test the strategy’s performance on different time frames and past periods to minimize the role “randomness” plays in your results. This will also prevent you from becoming overconfident when placing future trades.
Trading Setup Examples
The issues from using similar technical analysis indicators might sound a bit unclear on paper. At the same time, combining several indicators that can all work together in harmony might appear too complex.
To help you on that front, we will go through two scenarios – one where we combine three different indicators that can work together perfectly, and one where we have indicator redundancy.
Combining Three Indicators from Different Groups
The indicators we are about to use for the example include:
Average Directional Index – a trend indicator
Relative Strength Index – a momentum indicator
Bollinger Bands – a volatility indicator
As you can notice, these are all indicators from different groups. The idea is to ensure different complementary signals and a broader picture of the price action.
In the example below, you see that the Bollinger Bands indicate there is a price breakout. This means the trend is likely to start reversing. However, we don’t make a move at this point, considering that Bollinger Bands is highly unreliable if used on its own.
Next, we look at the RSI to see whether it will confirm the signal from the Bollinger Bands. The RSI is above 70, confirming that the market is entering overbought territory, and the price will likely start decreasing.
Note that some traders will usually sell at this point, but to show that there are ways to use three indicators at once, without redundancy, we will also check what the ADX signals. The trend indicator alerts that the trend is strong.
In this situation, we have three indicators complementing each other’s signals. Alternatively, we get a reliable indication that the trend will reverse after that, as you can see from the picture above.
Combining Three Redundant Indicators
We will go through an example where three momentum indicators (the RSI, MACD, and Stochastic) are applied on the same chart to see what happens.
The example below shows that all three indicators provide the same information since they are from the same category – momentum indicators.
The only thing such a combination of indicators achieves is complicating the chart. Whatever you would have predicted with either of the three, the same as you would expect when applying all of them together. All three momentum indicators rise and fall simultaneously. They also turn and trend together, providing virtually no upside for using all of them on a single chart.
However, there are worse situations than this, where redundant indicators provide misleading signals.
To Sum Up
The perfect combination of indicators isn’t the one always pointing in the same direction. The ideal indicator combination is the one that analyzes different aspects of the price action to give you complementary signals. That way, you can be confident that you aren’t losing potentially-profitable opportunities. More importantly, when you aren’t following misleading signals, that will lose you money.