Here, we will review the different types of technical indicators, demonstrate how to apply complementary technical indicators to enhance a trading strategy and explain the importance of selecting dissimilar indicators to avoid multicollinearity, a condition that results from employing multiple similar component techniques.
Indicators often are divided into four categories based on what each group measures:
Trend indicators measure the direction and strength of a trend and typically use some form of price averaging to establish a baseline. Momentum indicators track the speed at which prices change by comparing prices over time. Volatility indicators provide information about the trading range in a given market and its acceleration and deceleration. Volume indicators represent the amount of trading activity that has occurred and analyze the force behind a price movement.
For the most part, indicators by themselves do not provide trading signals. Instead, each trader must interpret the information to determine trade entries and exits based on his or her own trading logic, style, risk tolerance and even chosen trading instrument. Incorporating different types of indicators into a trading strategy (such as by applying one trend and one momentum indicator) will provide better results than using multiple indicators of the same type.
An important part of using technical indicators is to experiment with innovative ways of applying them to the markets. While technical indicators often have a recommended application, traders are by no means limited to those rules. Traders can rely on their own research and market observations to build a better mousetrap.