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Why Adding Indicators Hurts Your Trades |
by John Jagerson
I hear investing "instructors" suggest that adding several technical indicators will increase the probability of a successful trading outcome. This is a fallacy that plagues a lot of traders, especially new traders. Trading the market is not just a numbers game but there are some things we know about statistical analysis that can help you understand why this is a fallacy and why it can hurt your trading returns.
Assume that you are encouraged to use three different technical indicators. The first is a stochastics that has delivered a 40% probability of a successful trade in the past. The second indicator is a MACD with a 30% probability of success. The final indicator is a moving average with a 20% probability of signaling a successful trade. If you wait for all three indicators to agree, what is your probability of a successful trade?
Many of the instructors and authors I have seen would suggest that your probability is cumulative. Therefore, based on the numbers above your probability would equal 90%. It doesn't take long for traders to realize that simply adding indicators does not actually result in those kind of returns - why not?
Technical analysts are indicators to make a statistical estimate of a successful trade outcome. However because one technical indicator does not affect another the analysis is being conducted "with replacement." That is a statisticians way of saying that because the indicators cannot affect each other, merely adding more of them to a chart will not increase the probability of being right. In fact, from a statisticaly perspective, the probability of a successful outcome always going to be equal to the most accurate indicator or 40%.
The danger of this kind of analysis is that by waiting for confirmation from several indicators you have maximized the amount of lag before taking a trading signal by not taking action until they all agree. This decreases the average time you are in a trade and its profit potential. Assuming that risk control (stop losses) remain constant, you have shifted the risk reward ratio further out of your favor. That is a very dangerous thing to do.
The underlying message here is a positive one. Managing and waiting for a dozen indicators to agree is time consuming and confusing. Specializing and becoming proficient in your analysis by simplifying the tools you are using is easier and does not come with disadvantages. To learn more about technical analysis, click here.
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