Technical Indicators Strategy (Backtest And Example)

Last Updated on January 11, 2023

For most technical traders, the use technical indicator strategy is a reliable way to trade the financial markets. Combined with the right risk management tools, it could help a trader gain more insight into price trends and forecast how the price might move in the future. Want to know about technical indicator strategy?

A technical indicator strategy refers to a method of analyzing the price of securities using technical indicators. It includes market analysis to spot trade entry and exit points. Some of the common indicators for this strategy include moving averages, stochastic, RSI, MACD, Bollinger Bands, and so on.

In this post, we answer some questions about technical indicators strategy. We end the article with a backtest.

What is a technical indicator trading strategy?

A technical indicator strategy refers to a method of analyzing the price of securities using technical indicators to spot trade entry and exit points. Technical indicators are trading tools created from calculations based on the price, volume, or open interest of an asset or contract. These indicators are useful in the identification of trends, and trend reversals, and also to provide trade ideas.

A technical indicator strategy involves selecting and utilizing a specific set of indicators to make informed decisions about when to buy or sell an asset. Different technical indicators are used by traders. Some of the most common indicators include moving average, stochastic, and Bolliger bands. It is important to consider how the indicators work together and the timeframe in which they are being applied.

When using a technical indicator strategy, the goal is to choose a particular set of indicators and use them together to precisely time the entry and exit points in the price of an asset. This can involve setting certain conditions for each indicator and specifying how they should work together. For example, a trader may use a moving average and relative strength index together, with the condition that a buy signal is triggered when the price is above the moving average and the relative strength index is above 30.

What technical indicators are used in trading strategies?

Some common technical indicators used in trading strategies include:

  • Moving averages. A moving average is used to smooth out price data and spot trends. It is the average price of the securities over a given period.
  • Relative strength index (RSI). The RSI is a momentum indicator that measures the magnitude of recent price changes to identify overbought or oversold conditions.
  • Bollinger bands. Bollinger bands are a type of volatility indicator that uses standard deviations to set upper and lower bands around a moving average. Its outer bands can help identify potential entry and exit points.
  • Stochastic oscillator. The stochastic oscillator is a momentum indicator that compares the closing price of a security to its price range over a certain period to identify overbought or oversold conditions.
  • Moving average convergence divergence (MACD). The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price.

How do I choose the best technical indicators for my trading strategy?

There are a few key considerations to keep in mind when choosing technical indicators for your trading strategy:

  • Relevance to the market and security being traded. The indicators you use should apply to the market and the asset you are trading. For instance, an indicator that is good at spotting trends in the stock market would not be good in a market that is range-bound.
  • Timeframe. Different technical indicators may be more or less suitable for certain timeframes. For example, a long-term trend-following indicator may not be as effective for identifying short-term trading opportunities.
  • Compatibility with your trading style. It’s crucial to pick indicators that go along with your trading strategy and goals. A trader seeking to capture short-term price swings, for instance, could favor a different set of indications than a trader seeking to find long-term trends.
  • Avoiding indicator overload. To reduce complexity and confusion, it is typically better to keep the number of indicators in a trading strategy to a minimum. Having too many indicators might complicate data interpretation and cause contradicting signals.

How do I create a trading strategy based on technical indicators?

To create a trading strategy based on technical indicators, follow these steps:

  • Define your trading objectives. Your trading goals should be clearly stated, including the kind of security you want to trade, the time range you are considering, and the amount of risk you are willing to take.
  • Select technical indicators. Select technical indicators that are appropriate for the time range being considered, applicable to the market and security being traded, and consistent with your trading strategy and goals. Use as few indicators as possible; too many indicators make things a lot more complex, and one rule in trading is, “the simpler, the better”.
  • Define your entry and exit points. Use the technical indicators to identify potential entry and exit points for trades. This may involve setting certain conditions for each indicator and specifying how they should work together.
  • Incorporate risk management. Incorporate risk management techniques such as stop-loss orders and position sizing to mitigate potential losses.
  • Convert your strategy to a trading algorithm: Write the code for your strategy, specifying the entry and exit rules, as well as position sizing and other risk management parameters.
  • Test and refine your strategy. Backtest your strategy using historical data to see how it would have performed in the past. Make any necessary adjustments and continue to test and refine the strategy as needed.

What are the most important factors I should consider when trading with technical indicators?

  • The type of indicator. Trend, momentum, and volatility are just a few examples of the various types of information that different indicators can offer. It’s critical to pick the appropriate indicator for your trading strategy.
  • The sensitivity of the indicator. Some indicators are more sensitive than others and may produce more signals. This can be helpful if you want to trade frequently, but it can also increase the risk of false signals.
  • The market you want to trade. Some indicators work better in some markets than in others. A trend indicator will do poorly in a market that is range-bound.
  • The timeframe. The timeframe you use can affect the signals you receive from the indicator. A shorter time frame may provide more frequent but less reliable signals, while a longer time frame may provide fewer signals but they may be more reliable.

What kind of backtests should I run on a trading strategy using technical indicators?

There are several types of backtests that you can run on a trading strategy using technical indicators:

  • In-sample backtests. In-sample backtests use a portion of the available historical data to test the strategy. This can be useful for identifying patterns and fine-tuning the strategy, but may not provide a complete picture of the strategy’s performance.
  • Out-of-sample backtests. Out-of-sample backtests use a portion of the historical data that was not used in the in-sample backtest to test the strategy. This can provide a more realistic evaluation of the strategy’s performance, as it is based on data that the strategy has not seen before.
  • Walk-forward backtests. Walk-forward backtests involve re-optimizing the strategy on a rolling basis using updated data. This can be useful for testing the robustness of the strategy and its ability to adapt to changing market conditions.

How do I interpret the results of backtesting a technical indicator trading strategy?

Some of the performance metrics that can be used to interpret the results of backtesting include the percentage of profitable trades, average profit or loss per trade, maximum drawdown (the largest drop from a peak to a trough), and Sharpe ratio (which measures the risk-adjusted return of the strategy).

Another factor to take into account is the strategy’s overall consistency in different market environments. A strategy’s performance during a backtest cannot tell how it will perform in the future because it is based on prior data and cannot account for all potential future performance variations.

How do I decide when to adjust or abandon a technical indicator trading strategy?

It could be necessary to make adjustments or even think about giving up the strategy if it is not achieving your trading goals or it is performing poorly compared to other techniques. It is crucial to keep tracking the strategy’s effectiveness in real time and make any adjustments when results are not good enough. If it becomes obvious that market conditions have changed, you can abandon the strategy. For example, a range-focused strategy can be abandoned if the market starts trending.

What are the most common mistakes made when using technical indicators in trading strategies?

They include:

  • Using too many indicators. Using too many indicators can make the strategy too complex to be successful.
  • Relying on a single indicator. Relying on a single indicator can be risky, as it may not provide a complete picture of the market. It is generally best to use a combination of indicators.
  • Neglecting risk management. It is essential to incorporate risk management techniques such as stop-loss orders and position sizing to mitigate potential losses.
  • Failing to consider the timeframe. Different technical indicators may be more or less suitable depending on the time frame being considered. It is important to choose indicators that are appropriate for the timeframe being traded.
  • Not testing and refining the strategy. It is important to backtest the strategy using historical data and to continue to test and refine it as needed.

How can I combine different technical indicators to create more effective trading strategies?

It is crucial to think about how the indicators interact with one another when trying to create an effective strategy. Use indicators with complementary strengths — a trend indicator and an oscillator. For example, you can combine a moving average with the RSI or any other indicator that overbought/oversold levels. While the moving average tells you the direction of the trend, the RSI can tell you when to buy in the trend direction.

How do I identify which technical indicators provide the best signals for a trading strategy?

You have to consider the condition of the market you want to trade and the indicators that suit the market the best. However, to find out which technical indicators work best for your trading strategy, it may also be useful to try a variety of them and backtest them to see how they perform.

How does my trading strategy need to adjust when the market conditions change?

Your trading strategy may need to be modified when market conditions change to remain effective. This means you have to monitor your system to know when things are out of place so you can tweak the parameters of your strategy to suit the new market conditions. The robustness of the strategy and its capacity to adjust to shifting market conditions may be tested using walk-forward backtests.

What are the risks associated with trading strategies based on technical indicators?

There are several risks associated with trading strategies based on technical indicators, including the risk of relying on historical data, the risk of overfitting (creating a strategy that is too closely tailored to the data), and the risk of failing to consider the fundamental analysis and changing market conditions.

It is important to incorporate risk management techniques and to continue to monitor and adjust the strategy as needed to mitigate these risks.

How do I know when to enter or exit a trade based on technical indicators?

Your technical indicator strategy must have entry and exit triggers. These are specific signals the indicator must give before a trade is entered or closed. For example, if you are using an RSI plus 200-period moving average strategy, a buy signal could be the RSI climbing above 30 when the price is above the 200-period moving average.

How do I optimize my technical indicator trading strategy for the best possible results?

You will have to backtest it and also do a walk-forward optimization to ensure the robustness of the strategy before using it on a real account. Then, you should periodically check the trading results to know if the performance is as expected. When performance drops, you can tweak the parameters and test again for robustness.

Technical indicators strategy backtest

A complete backtest of a strategy with strict trading rules and settings is coming shortly.

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