Traders and analysts use technical indicators such as RSI, moving averages, Bollinger Bands and Stochastics to comprehend future trends, analyze the past and identify trading opportunities. A strategy is a result of both fundamental and technical analysis framed to dampen risk and increase profits. Indicators are an integral part of strategies used to determine the exit and the entry of a trade.
Volume, trend momentum and volatile are different classes of indicators. When three indicators of the same category are used, it results into the multiple counting of the same data; a statistical term denoted to as multicollinearity. Multicollinearity should be avoided as much as possible since it produces inoperable results. For instance, a moving average strategy may use a trend momentum to confirm the valid trading signal.
The RSI has user-defined variable inputs like other technical indicators and can be used to confirm any signals produced by moving averages. The usage of the combination of each indicator requires an extensive amount of research in order to determine the most appropriate application with respect to the trader’s risk tolerance and style. One of the biggest advantages to quantifying trading rules into a strategy is that it allows traders apply the strategy to historical data.
Now the question is what type of indicator to be applied. It depends on what category of strategy, which is intended to be built by analysts. This relates to trading style and risk tolerance. A trader seeking long-term moves with big profits may concentrate on a trend-following strategy, and hence, uses a trend-following indicator like moving averages. On the other hand, a trader interested in small moves with small gains might be interested in a volatility-based strategy. Technical indicators don’t alone produce trading signals. Every trader should define the exact method of applying indicators to formulate effective strategies and identify trading opportunities.
Technical indicators can definitely be used without being incorporated into a strategy. However, technical trading strategies normally include at least one type of indicator. Recognizing an absolute set of rules, as with a strategy, permits traders to backtest to determine the volatility of a particular strategy. It also aids traders understand the mathematical expectancy of the rules or how the strategy should perform in the future. This is critical to technical traders since it helps traders continually evaluate the performance of a given strategy.This article is useful for the students of Forex trading.