As we progress through the different ways in which we can use technical indicators to improve our understanding of stock price movements, you might start to notice how it is that the indicators become increasingly subjective. This is because of the way in which all of these formulas are simply tools for evaluating the overall trends, as opposed to absolute laws of the market. It is therefore only through contextual interpretation that we can come up with a reasonable conclusion about how it is that a technical indicator might show us an opportunity. Otherwise, we might find ourselves buying into a false trend that doesn’t really make sense.
Looking at the historical success rate of swing trading strategies that rely entirely on the use of technical indicators on their own, there is a fairly uncertain picture of the outcomes. Over the short term, testing a strategy that relies on the Bollinger Bands or Stochastic Oscillators to exclusively trade the position in accordance to what the indicator would define as a trend will generally create only a few opportunities, with a general tendency towards taking a slight loss on the position. However, over time, back-tested portfolios can show as some highly favorable yearly returns.
Unfortunately, these results are still few-and-far between, and not necessarily indicative of an actual forward moving trend. Therein lies the first major setback of using technical indicators exclusively in a trading strategy: the use of backward looking data is not ideal for building a forward looking strategy because we are very likely to manipulate the metrics being used to suit the past trends, as opposed to creating an indicator representative of future movements. This trait is known as the “data mining” bias.
In order to overcome the data mining bias, we need to make sure that our technical analysis is robust enough to identify a full blown future-looking trend, as opposed to a statistical correlation in previous data. This can firstly be accomplished by combining multiple trading indicators, to ensure that the price point does actually represent an opportunity.
For example, if we have both a volume-based and price-based indicator lining up to show us an opportunity, there is a better chance of success than if we simply moved on one or the other. From there, we can also look at the correlations between the two indicators. If one indicator precedes the other, than we are able to see a position begin forming over time, and therefore better predict the movements of the security over time.
The final trick to implement a technical trading strategy is to test the system on a forward moving basis through the use of a practice portfolio. By running the strategy through a practice portfolio, we are able to both verify the ability of the strategy to perform, understand the timeline over which it will likely produce its returns, and then get a feeling for how it is that the strategy suits our personal goals. In gaining this understanding, we can then start to implement the strategy into our portfolio by using it to help us determine the best buy and sell prices to get us into and out of the positions that we have deemed as having a strong fundamental investment quality to them.