Technical indicators are used by traders and investors for technical analysis. They analyze the past and the present to approximately predict the future. This analysis helps traders to chart future price trends and patterns. Technical traders rely on indicators to help them interpret the market. The goal of the indicators are to find trading opportunities in the stock market. A large number of technical indicators are used by traders to study for example a moving average or a stochastic oscillator. Most of these indicators have variables that are set down by their users, the traders in this case to suit their own needs.
On the other hand, strategies are implemented to use indicators objectively and determine trade management rules. A strategy is governed by a set of rules that specifies how the trades will take place. They normally use multiple indicators for better trading. Typical strategies include both trade filters as well as trade triggers, which in turn are based on indicators. While trade filters help you identify the conditions, the triggers identify when an action should be taken.
Using Technical Indicators to Develop Strategies
The first thing that you should keep in mind is that an indicator is in no way a trading strategy on its own. An indicator will help you to identify while a strategy will use these indicators to lay down rules. You can select different trading tools from different categories like trend, volume, momentum and volatility. Traders will employ multiple indicators in order to form their strategy and there should be a variety in the type of indicator used for better visibility. For example, if three different momentum indicators are selected, it results in multiple counting of the same information. Such a situation is called multicollinearity and it often makes other variables less valuable. So, if you select indicators from different categories to use in a strategy, you will definitely end up with better results. Also, you will be able to check the accuracy of one indicator through the function of another.
But you have to conduct your own research to conclude which indicator and what combination is best suited to your trading style. You always have the option to run your strategies on historical data so that you can evaluate for yourself how the strategy will perform in the present from its performance in the past. This is often termed as back testing. However, there is no guarantee because the stock market is a volatile place, but it does help to understand the strategy better.
However, a strategy has to identify how the indicators will take action because these are nothing but tools that will help you develop a strategy, they cannot create trading signals on their own.
How to Choose Indicators to Develop your Strategy?
Choosing an indicator or indicators for your trading strategy is extremely crucial and depends completely on your purpose. Depending on your risk appetite and style of trading, you can pick your indicators. If you seek long term moves that result in large profits, you should focus on picking up trend following indicators such as a moving average which will help you build a trend following strategy. If you are more interested in smaller moves and smaller gains, you will have to pick up an indicator for volatility. You should also pick up confirmation indicators that will complement other indicators and check their accuracy to make sure everything is in order.
However, when it comes to stock market trading, there is no hard and fast rule or surefire ways to make money. You will have to arrive at the best possible solution suited for your purpose through a series of trial and errors.