To improve market analysis (and the odds of a successful trading system), traders should use complementary indicators — those that present different views of the market while working collectively to provide meaningful data on which to base trading decisions. Because complementary indicators provide unique — rather than redundant — information, they can be used together to provide confirmation for trading signals.
Each indicator that is used in a trading strategy should serve a distinct purpose and provide a unique perspective of the markets — such as to measure momentum or evaluate the overall trend. Like a so-called elevator speech used to explain a product’s purpose in a succinct, pointed delivery, traders should be able to explain concisely why an indicator is on a chart. Answering two questions is paramount: What is it that makes this indicator an important part of the strategy? What unique information does this indicator provide?
We can compare two trading systems to demonstrate the advantages of using complementary indicators. In the first system, only one technical indicator is used to generate trading signals for a simple stop-and-reverse strategy. For the second system, a complementary indicator is added that provides a filter, or confirmation, for the trades. If the conditions are not met, the trade will not be initiated.
“Simple system” (above) shows the basic stop-and-reverse strategy that uses only a stochastic oscillator (a momentum indicator) with the settings 30 for the length, 3 for the first smoothing input and 3 for the second smoothing input. The strategy enters a long trade when two conditions are met:
- SlowK line crosses over SlowD line
- SlowK line is below the oversold territory of 20
A short trade is entered when:
- SlowK line crosses under SlowD line
- SlowK line is above the overbought zone of 80
Ten years of historical E-mini S&P 500 futures data were included in the test (June 17, 2002 through June 19, 2012). The summary performance report is displayed on the chart. This tells us that the strategy shows a profit factor of 1.50, indicating that this strategy would be profitable. While the results are acceptable, adding a complementary indicator can improve performance.
The system is enhanced using a complementary trend indicator to help determine the direction and strength of the trend. For this, a simple moving average crossover is used with lengths of 50 and 60. This adds one additional condition to trade entries:
- For long trades, the 50-period average must be greater than the 60-period average.
- For short trades, the 50-period average must be less than the 60-period average.