To be able to create simple but profitable strategies with few parameters that still has an edge you need to use slightly more advanced tools, this is where technical indicators come in. They help traders determine market trends, potential entries and exits, and the power of a price movement. Incorporating these signals into a strategy would allow traders to maximise the efficiency of fewer parameters with robust and profitable edges.
Most technical indicators have a main parameter which is the common way to generate signals but most indicators can be used in multiple different ways, these more uncommon ways to generate signals doesn't necessarily need to be more advanced they are just slightly more hidden and therefore can generate more profitable entries, exits or filters for your strategy.
Here are some popular technical indicators that you may incorporate into your algorithmic trading strategy:
Moving Averages (MA)
You may use moving averages to create a smooth line applied to price data to recognise momentum trends over particular periods. We have a list of 11 Essential moving averages but there are two primary types of moving averages:
Simple Moving Average (SMA): The SMA line represents the average of instrument prices over the defined periods.
Exponential Moving Average (EMA): The EMA is a variant of the moving average but applies more weight to the recent prices, making it more accurate to recent information.
Here are the most commonly used periods of moving averages with respect to the timeframe:
Short-term: 10, 20 days
Medium-term: 50 days
Long-term: 100, 200 days
Trend Identification
Traders use moving averages to determine the overall market direction.
In a bull trend, the price is above the moving averages.
In a bear trend, the price is below the moving averages.
Trend Reversals
Moving average cross-overs are used to predict trend reversals.
Golden Cross: When a short-term MA crosses above a long-term MA, this may indicate the start of a potential bull trend.
Death Cross: When a short-term moving average crosses below a long-term MA, this may indicate the start of a bear trend.
Support and Resistance Levels
Moving averages are also used as dynamic support or resistance. If a security is in an uptrend and trading above its moving average, the pullback toward the moving average will often be a key area of interest for buyers.
On the other hand, if the moving average is above the price, traders often look to sell on the retests of the moving average.
Filtering Out Noise
Moving averages provide a better picture of the trend by straightening price data to eliminate excessive noise, especially in a volatile market.
Our favourite way of incorporating the Moving Average into a strategy criteria have been to use price > low timeframe (5-20) as an exit criteria, this works very well on Mean-Reversion strategies.
Relative Strength Index (RSI)
Relative Strength Index measures the pace and level of recent price movements to help determine whether an asset is overbought or oversold. Values greater than 70 indicate an overbought status, and values less than 30 indicate oversold.
RSI Divergence
Bullish Divergence: Prices making lower lows and RSI increasing higher lows indicate upward movement.
Bearish Divergence: Prices making higher highs and RSI making lower highs indicate an upcoming downward movement.
Combining with Other Indicators
To be more accurate, traders often combine RSI with other indicators:
Moving Averages to confirm trends and entry/exit points.
MACD to filter trend changes with the RSI signals.
Mean Reversion
When the price is in a strong trend, and the RSI is above 70 or below 30, traders usually go against the trend, anticipating that the price will pull back towards its mean before continuing in the trend direction.
Trendline Breakouts
Drawing trendlines on the RSI chart allows traders to identify potential breakouts. When the RSI breaks above or below the trendline, it indicates the breakout on the price chart respectively.
Moving Average Convergence Divergence (MACD)
MACD illustrates the relationship between an asset's price and its two moving averages. The most common way to use the MACD is a crossover of those moving averages after overbought or oversold provides signals to buy or sell.
Signal Line Crossovers
One of the primary methods for using MACD is through signal line crossovers. This occurs when the MACD line crosses above or below the signal line (a 9-period EMA of the MACD).
Bullish Signal: When the MACD line crosses above the signal line, it indicates a potential buy opportunity.
Bearish Signal: Conversely, when the MACD line crosses below the signal line, it suggests a potential sell opportunity.
Zero Line Crossovers
Bullish Zero Crossover: When the MACD moves above zero, it signals that the shorter-term EMA is greater than the longer-term EMA, suggesting an uptrend.
Bearish Zero Crossover: When the MACD falls below zero, it indicates that the shorter-term EMA is less than the longer-term EMA, suggesting a downtrend.
Divergence Analysis
Bullish Divergence: When prices make lower lows while the MACD makes higher lows, indicating weakening downward momentum and a possible reversal to an uptrend.
Bearish Divergence: When prices reach higher highs while the MACD makes lower highs, suggesting weakening upward momentum and a potential reversal to a downtrend.
Overbought/Oversold Conditions
A significantly high histogram may indicate that an asset is overbought, while a significantly low histogram may suggest it is oversold. Traders often look for confirmations from price action or other indicators before acting on these signals.
Trend Confirmation
In a strong uptrend, traders might only take buy signals generated by MACD crossovers.
In a downtrend, they would focus solely on sell signals to avoid false positives during choppy market conditions.
Bollinger Bands
Bollinger Bands comprise an SMA in the middle and two bands on either side to indicate volatility. When the price hits the upper band, it indicates overbought conditions; when the price touches the lower band, it indicates oversold conditions.
Trend Strength
A strong uptrend often sees prices touching the upper band regularly, while a strong downtrend will have prices lingering near the lower band. If prices fail to reach these extremes during a trend, it may indicate weakening momentum and potential reversal.
Bollinger Breakout
When the bands contract tightly, indicating low volatility. A breakout from this squeeze can signal a significant price movement in either direction. Traders look for confirmation through candlestick patterns or other indicators before entering trades.
Bollinger Bounce
Traders might buy when prices bounce off the lower band and sell when they bounce off the upper band.
Reversals
W-Bottom: A pattern where the price makes two lows above the lower band before rising.
M-Top: A pattern where the price makes two highs below the upper band before declining.
Stochastic Oscillator
The Stochastic Oscillator compares a specific closing price of a security with its price range over a given period. Values above 80 are considered overbought, and below 20 are considered oversold, this is the most common way to use Stochastic.
Crossovers
Buy Signal: Occurs when the %K line crosses above the %D line below the 20 level.
Sell Signal: Occurs when the %K line crosses below the %D line above the 80 level.
Traders often look for these crossovers as potential entry or exit points, especially when they occur in extreme zones.
Divergence Analysis
Bullish Divergence: When prices make lower lows, but the Stochastic makes higher lows, suggesting weakening bearish momentum.
Bearish Divergence: When prices make higher highs while the Stochastic makes lower highs, indicating weakening bullish momentum.
Combining with Other Indicators
Using the Stochastic Oscillator in conjunction with other technical indicators can enhance trading decisions:
Moving Averages: Helps confirm trends and filter out false signals.
Support and Resistance Levels: Provides context for overbought or oversold signals.
Trendlines: Assists in identifying potential breakout points.
Timeframe Considerations
The effectiveness of the Stochastic Oscillator can vary across different timeframes:
For short-term trading, use lower timeframes (e.g., hourly charts).
Consider higher timeframes (e.g., daily or weekly charts) for long-term trading to align trades with broader market trends.
Adjusting Settings
Traders can customise the settings of the Stochastic Oscillator to suit their trading style:
Common settings include (5,3) for fast stochastic and (14,3) for slow stochastic.
Adjusting these parameters can help reduce noise or increase sensitivity based on asset or market conditions.
Final Thoughts
Knowing different indicators and the more uncommon ways these can generate signals can help you create simple yet more profitable trading algorithms, and using the appropriate tools and process can take your trading to a whole new level.
One should not forget that no technical indicator is always accurate and should be considered in addition to other factors like risk management, position sizing, or diversification in the creation of a trading strategy. In addition, indicators is always a lagging tool and all strategies should be created using a robust process to minimize the risk of creating curve-fitted strategies. After all, the most important target to systematic traders should always be to avoid curve-fitted strategies.
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