While using multiple indicators in a trading strategy can improve results, using the wrong combination of indicators can hurt a system. Some traders may intentionally apply similar — rather than complementary — indicators with the objective of finding confirmation for a trading signal. The problem with using similar indicators — such as two momentum indicators — is that it really provides no confirmation at all because it produces only duplicate results. The two indicators may appear to confirm one another, but this is only because each is based on the same math.
Multicollinearity is a statistical term that refers to the multiple counting of the same information. It occurs when similar indicators are used at the same time. If highly correlated indicators are used to quantify market activity, the results are less meaningful than if different types of indicators are used as part of a strategy. If all indicators are based on the same closing prices, for example, no new information is produced, and therefore, no true confirmation is provided (see “Replicating efforts”). It is akin to trading similar markets in one sector in a mistaken attempt to diversify your portfolio.
A simple method of determining if indicators measure the same thing about the markets is to review their results on a single chart. If each indicator provides similar signals and they move in the same general manner, they likely are collinear and should not be used together. “Replicating efforts” shows a daily chart of the E-mini S&P 500 with a stochastic oscillator and the Commodity Channel Index (CCI) indicator applied. Both the stochastic and CCI are momentum indicators, and both, for this example, have been set to the same length of 30. We can see from the chart that the indicators produce nearly identical results. Using these two indicators together would be detrimental to a strategy because they produce redundant signals with no true confirmation. A second indicator should not catch the same signals, instead it should reduce the number of signals and confirm the more successful — either by percentage or magnitude — signals of the first indicator.
Traders and investors use technical indicators to evaluate past and current market conditions to predict future price movements. To maximize the odds of success for a trading strategy, it is important that each individual indicator provides a different view, and collectively a comprehensive view, of past and current activity so that traders can build a trading model better equipped to forecast the future ups and downs of market prices.
Jean Folger is the co-founder of, and system researcher at, PowerZone Trading LLC. She can be reached at www.powerzonetrading.com.