The golden rule of combining
When it comes to combining different indicators, there is one ground rule: do not overdo it.
Having multiple indicators applied on the chart does not improve your results. On the contrary, it can confuse you and give out or confirm wrong signals.
Before going into combining indicators, it is important to understand the difference between them. All indicators can be divided into several categories:
1) Trend indicators. Trend-following indicators smooth out the price and follow the trend line of the chart. They are based on the past performance of the asset and show the price trend and its strength. These indicators are normally placed on the chart line.
2) Momentum indicators (oscillators). These indicators aim at determining the overbought and oversold levels and they are effective for finding price reversal points. They are usually displayed under the chart, so it is easy to distinguish them from the trend ones.
3) Volume indicators. This class of indicators shows the volume of the traded asset. Tracking the volume is useful in order to see how strong the price movement might be.
4) Volatility indicators. These indicators show how much the price of the asset is changing in a set period. The price has to be volatile in order for a trader to be able to trade it, but high volatility is associated with higher risk.
When combining indicators, it may be preferable to use indicators from different groups, rather than several indicators of the same type. Let’s check some examples of 3 useful indicator combinations that may be applied in trading.
RSI + Bollinger Bands
The RSI is an oscillator with the standard levels of 70 and 30 displayed on the chart. It is a line that fluctuates between the values of 0 and 100, and when the line gets close to 70, the asset is considered overbought, when it approaches 30 – it is considered oversold.
Bollinger Bands (BB) consists of three lines: one exponential moving average (EMA) and two price channels above and below it. It shows the periods of high and low volatility of the asset. The more wide apart the Bands are, the higher the volatility and the stronger the movement is.
With these two indicators combined, a Buy signal is received when candlesticks cross the bottom line of BB and the RSI line crosses the oversold level and starts moving up. A Sell signal is received when the chart crosses the upper band and the RSI is in the overbought level, starting to reverse down.
SMA + Stochastic
The Simple Moving Average (SMA) is considered a basic tool but by smoothing the price fluctuations (noise) it may help a trader see the real picture of the market direction.
The Stochastic Oscillator displays possible overbought and oversold levels. It is a leading indicator and it provides the indication for possible price reversals. It works well when combined with a lagging indicator like SMA, which is calculated based on the information of the past performance of the asset.
Using these two indicators together, the following signals might be indicated. When the market breaks the SMA line from below upwards and the blue line of the Stochastic crosses the red line upwards, it may be a sign of an upward trend. A signal of a downward trend is received when the market crosses the SMA line from above downwards and the Stochastic shows the blue line crossing the red line downwards.
ATR + Parabolic SAR
ATR is a volatility indicator, it does not display the direction of the trend, but it measures how volatile the market is. And when the market is unstable, it shows potential trading opportunities. At the same time, ATR can help a trader decide on setting the Stop Loss level. In moments of high volatility, there is a higher risk, which might be managed with a Stop Loss.
Combining ATR with Parabolic SAR – a trend indicator – may help the trader find entry points during a trending market while setting potentially more accurate Take Profit and Stop Loss levels.
Combining these indicators, one may watch for the signals given out by Parabolic SAR. A Buy signal is received when the dotted line is below the price chart. A Sell signal is received when the dotted line is above it. A possible entry point is marked when the Parabolic moves from one position to another (for instance, it changes from being above the candle chart to moving below it).
Combinations of technical indicators may be a powerful analysis tool and the understanding of how to do it is very valuable for a trader. With that said, it is important to understand that there is no indicator or combination of indicators that will show 100% accurate signals all the time. Any indicator may show false signals from time to time, which is why a trader needs to apply necessary risk management strategies.