4.38 Indicators Put Together – The Complementary Approach

 
Combining technical indicators.
 
As we have mentioned, time and again, that technical indicators are not magic. In fact, at times, you need to analyze the signals of your technical indicators. Complicated? Technical indicators analyzing the price action and you analyzing their analysis!!! 
 
Well, who said that life is simple? And who said that making money is a piece of cake?
 
We’ve kept harping about how to use ‘confirmation’ in our technical analysis by checking out one tool with another tool such as trend analysis, support and resistance levels or averages. And we wish to repeat the same again.
 
Now that we’ve armored ourselves with quite a few technical indicators, let’s try the confirmation route, playing ‘mix-and-match’ by combining one indicator with another.
 
You see, by doing this we improve the risk-to-reward ratio of our trades. This means we stand to win more than we are likely to lose on that trade.
 

Complementing and not Competing

 
To make a trading decision you would like to know the trend situation, the momentum of the trend, the volatility of the price-action and for some of the trading markets, the volumes i.e. the amount of trading activities. In fact we will go a step further to say that you will love to gauge the market sentiments also.
 
Considering the above the technical indicators can be categorized in the following types.
 
  • Trend indicators
  •  

  • Momentum Indicators
  •  

  • Volatility Indicators
  •  

  • Volume Indicators
  •  

  • Sentiment Indicators
 
A brief about the types of indicators is as follows:
 
 
Type Short Description Examples
Trend Indicators

 

To indicate the direction and strength of a trend

 

Moving Averages, MACD, ADX, Parabolic SAR
Momentum Indicators To identify the momentum or the speed of the change in price

 

Oscillators like Stochastic, RSI and CCI

 

Volatility Indicators

 

To gauge the volatility of the price-action

 

Bollinger Banda and Average True Range etc.
Volume Indicators*

 

To estimate the trading volume or trading activity in the market

 

On Balance Volume, Rate of Change, Chaikin Oscillator
Sentiment Indicators

 

To gauge the market sentiment 

 

Chart Patterns, Candlestick patterns, Trend lines, Support & Resistance Levels, Psychological price levels
 
*Note: We do not go much for the volumes as far as Forex trading is concerned as it is not a centrally traded and cleared market and there is no single exchange or place to know about the trading volumes. AT the most you can have a feel about the volumes traded with your broker but that will be like a drop of water in the ocean.
 
So let’s get back to complementing versus competing. Do not, repeat DO NOT try to use same type of indicator to confirm the signal of any specific indicator. For example if stochastic is giving a buy signal because of it’s overbought or oversold situation, there is no need to cross-check it with RSI which is another momentum oscillator. In fact it is better to stick to as few indicators as possible in each type and master those.
 
Complementing is the name of the game. Check what your momentum indicator is saying while you are listening to your trend indicator or check signal of your volatility indicator with your momentum indicator. Use the complementary strength of all your tools.
 

Two Step Approach

 
We advise to follow the following approach:
 
  1. Check your indicator’s result against the sentiment indicators like trend lines, chart and candlestick patterns and psychological price levels. 
  2. Check complementary indicators.
 
Examples of the combination of Technical Indicators and sentiment indicators:
 
 
Complementing technical indicators with trend lines. 
 
The above chart is self-explanatory. However, let’s review the facts once again:
 
  1. There was a month long downtrend from mid-December to mid-January, and the price action has been in a descending channel. 
  2.  

  3. During the week of January 19th, there were three consecutive green candles. However the length and shape indicated a fear of upside.
  4.  

  5. The narrow sideways movement was followed by a big red candle which caused a bearish breakout of the channel. 
  6.  

  7. Bothe the above facts throw a bearish light on the price-action.
  8.  

  9. Price again tried to move up and MACD and RSI both offered bullish signals.
 
In the above example, taking a long position based on the signals alone may prove to be a bad idea, till the indicated resistance levels hold good. Advice – give preference to trend-lines and any other resistance or support levels.
 
Let’s see what happened next:
 
 
Chart showing the failure of the signal from the technical indicator. 
 
 
As indicated by the above chart, the “buy” signal from MACD and RSI failed against the resistance line and the coming days say a fall of approximate 900 pips.
 
While we are on it, let’s also try to see what we meant by keeping any eye on the psychological price levels and supports and resistances offered by those. The following chart explains it visually:
 
 
Complementing technical indicators with psychological price levels.
 
 

Using Complementary Mathematical Technical Indicators for Confirmation

 
For starters we’ll match up MACD and RSI and see how they hit it off on a chart to signal a buy, or a sell.
 
 
Complementary combination of MACD and RSI.
 
See the vertical lines tagged as 1 to 7 in the above chart. Let's talk about these one by one. 
 
  • Line 1 points to a situation when RSI is turning up from the overbought zone and suggests that there might be an opportunity to go for a long position. But wait. Let's have a look at MACD at the same time. The MACD remains below it's trigger line, right? Let's not jump into a trade and wait for the next opportunity.
  •  

  • Line 2 is drawn when RSI again emerges from the overbought zone. This line has another tag as 3 where shortly you can see the MACD crossover to the upside. This was a good place to enter a long trade.
  •  

  • Line 4 is drawn where MACD main line dropped sharply and though a decisive crossover did not take place but a hurriedly taken short position would have run into losses as the price jumped up soon after. Check the RSI at that point. RSI was clearly not showing any bearishness at that point of time and hence was not confirming to the MACD.
  •  

  • Lines tagged 5 and 6 show RSI an overbought position but MACD waving bullish gaps with the signal line and at such times it is better to ignore the overbought signals of the RSI.
  •  

  • Line tagged by number 7 is where MACD had a bearish crossover and RSI dropping down from the overbought position. These confirming indicators, coupled with the bearish engulfing candle formation on the price, were red flags for bears and the price fell down.
 
On why the RSI is signaling ahead of MACD – it’s just the way the oscillators constructed – each has its own peculiarities.
 
 
This brings us to deciding which oscillators to use. The best way is to learn through trial and error, practice and analysis of profits and losses. Each of us is a special kind of trader, and we have to find the special combination that works for us.
 
 
That was fun. Let’s do it again and hitch up Bollinger bands and stochastic. Is the suspense killing you? Here goes.
 
 
Complementary combination of bollinger bands and stochastic.
 
 
 
The above chart with Bollinger bands and stochastic oscillator is self-explanatory as to how these two indicators can be used in confirming and complementing each other. Hence let’s keep the further explanation simple and to the point. The trick of the game is to keep an eye on the following:
 
  1. The trend should not be very strong.
  2.  

  3. Whether stochastic is in either overbought or oversold zone or now.
  4.  

  5. Is there a bullish stochastic crossover in oversold zone or a bearish crossover in the overbought zone? You may like to ignore any crossovers signals while the stochastic is in the middle.
  6.  

  7. Caution is needed when the Bollinger bands are squeezing tightly as in such case a strong breakout in either direction is possible.
  8.  

  9. Is the price hitting the upper or lower band?
 

For buying:

 
Price should be near the lower band and stochastic should be in the oversold zone. Wait for a bullish crossover from the stochastic and you are on the go to hit the buy button.
 

For selling:

 
Price should be near the upper band and stochastic should be in the overbought zone. Wait for a bearish crossover from the stochastic and yes, it’s good to go short.
 
Check the points marked by W, X, Y, Z and P in the above chart.
 
The first point “W” - See that the price is at the lower band and the stochastic is turning up from the oversold 30 level. Not only that but stochastic gave a thumbs by the way of a bullish crossover. Checking out any bullish candlestick pattern in place may prove to be a bonus confirmation! Time to go long!
 
The price goes up to hit the upper Bollinger band (point X). In fact before that it had tried to breakout. The stochastic is in the overbought zone. Let’s wait to see if stochastic gives a thumb’s down by any bearish crossover below the trigger line. Yes it did and confirmed the Bollinger band signal. 
 
The “sell” was flagged off and the price took itself up to the lower band. Good trade, what!
 
Conclusion: looks like Bollinger and Stochastic got along like a house on fire!

 

    

        

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