Let's assume that you have 5 independent trading
indicators that, every day, show you possible future trends for the
market. To each indicator you assign a level of importance related to
how that particular indicator influences your final decision. Some
traders place the majority of their confidence in one indicator and
only use other indicators to confirm what they know from their
primary indicator. It is YOU who has to decide how to weight these
indicators, and which indicators you are going to consider at all.
For example, you could have a weighting similar to this:
1st indicator: 0.55 (55%) - Volume
Indicator
2nd indicator: 0.15
(15%) - Market Newsletters
3rd indicator: 0.15 (15%)
- Other Traders
4th indicator: 0.1 (10%) -
News / Talking Heads
5th indicator: 0.05 (5%) - Broker
Of course, all of these up to 100 percent.
Now, let us assume that a
situation arises on the market for which the first, and
highest weighted, indicator shows that the market is likely to
move higher. Is this indicator enough to base trading decision upon?
Could it be incorrect? The best way to evaluate that indicator is to
compare and contrast it with the others in your weighted list. Simply
assign a coefficient to each indicator (on a scale of -10 to +10)
based on what they predict for the future movements of the market.
For example:
1st indicator: +7
2nd indicator: -2
3rd indicator: -3
4th
indicator: 0
5th indicator: -4
"How do I know what coefficient, or level of
confidence to assign an indicator?"
Assigning coefficients to
your indicators in an entirely subjective task, which, unfortunately,
requires some experience before you master the system. Don't expect
to know what level of confidence to assign your first indicator on
your first day of using this system. What you assign as a +5 today
may be +3 to you after several months of experience.
Don't be afraid to test
the system. It cannot work for you until you get a good track record.
After assigning
coefficients to your indicators, simply multiply each indicator's
coefficient by its weighting and add them together:
(0.55 x 7) + (0.15 x -2) + (0.15 x -3) +
(0.1 x 0) + (0.05 x -4) = 2.9
The result is a signal strength of +2.9. Now,
unless you have a high risk tolerance, it probably is not a good idea
to base a trading decision on an indicator that is in the range of -4
to +4, as this is what we'd call the "uncertainty" range.
But perhaps the next day you assign the following
coefficients to your list of indicators:
1st indicator: +5
2nd
indicator: +6
3rd indicator: +2
4th
indicator: +4
5th indicator: +7
Now the summary signal will become:
(0.55 x 5) + (0.15 x 6) + (0.15 x 2) +
(0.1 x 4) + (0.05 x 7) =
4.7
In this situation, you are
probably more willing to open a long trade. With a confidence rating of
only 4.7 (0.7 above the threshold), perhaps you may want to think about
only opening a small long position until the confidence grows.
From
the above examples, you can see how additional indicators can reduce
your trading risk.
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