How to build a trading indicator


Elliott and Gann have become household names in the global business community. These pioneers of technical analysis developed some of the most widely used techniques in the field. But how did Ralph Nelson Elliott and WD Gann come up with these techniques, and how did they become so successful? Truth be told, it’s not as difficult as it sounds! This article takes you through the process of creating your own custom indicator, which you can use to get a leg up on the competition.

Background

Remember that the theory behind technical analysis states that financial charts take into account all things, that is, all fundamental and environmental factors. The theory goes on to state that these charts show elements of psychology that can be interpreted through technical indicators.

To better understand this, let’s look at an example. Fibonacci retracements are derived from a mathematical sequence: 1, 1, 2, 3, 5, 8, 13, and so on. We can see that the current number is the sum of the two previous numbers. What does this have to do with markets? Well, it turns out that these retracement levels (33%, 50%, 66%) influence traders’ decisions to such an extent that the levels have become a set of psychological support and resistance levels. The idea is that by finding these points on the charts, the future directions of price movements can be predicted.

Components of an indicator

All indicators are created to predict where a price is heading when a certain condition occurs. Traders try to predict two basic things:

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  • Support and resistance levels: These are important because they are the areas where prices change direction.
  • Weather: This is important because you need to be able to predict When price movements will occur.

Indicators occasionally predict these two factors directly, as is the case with Bollinger bands or Elliott waves, but indicators commonly have a set of rules enacted to make a prediction.

For example, when using the push amplitude indicator (which is represented by a line indicating momentum levels), we need to know which levels are relevant. The indicator itself is simply a line. The Amplitude Push Indicator looks similar to the RSI in that it is “range bound” and is used to measure the momentum of price movements. When the line is in the middle zone, there is little momentum. When it rises to the upper zone, we know that there is greater momentum and vice versa. You could think of taking a long position when momentum is rising from low levels and waiting short after momentum peaks at a high level. It is important to establish rules to interpret the meaning of an indicator’s movements so that they are useful.

With this in mind, let’s look at ways to create predictions. There are two main types of indicators: single indicators and hybrid indicators. Single indicators can be developed with only core elements of chart analysis, while hybrid indicators can use a combination of core elements and existing indicators.

Unique indicator components

Unique indicators are based on inherent aspects of graphs and mathematical functions. These are two of the most common components:

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1. Patterns

Patterns are simply apparent repeating price sequences over a given period of time. Many indicators use patterns to represent probable future price movements. For example, the Elliott wave theory is based on the premise that all prices move in a certain pattern that is simplified in the following example:

Elliot wave pattern.
Image by Sabrina Jiang © Investopedia 2020

There are many other simple patterns that traders use to identify areas of price movement within cycles. Some of these include triangles, wedges, and rectangles.

These types of patterns can be identified within charts just by looking at them; however, computers offer a much faster way to accomplish this task. Computer applications and services provide the ability to automatically locate such patterns.

2. Mathematical functions

Mathematical functions can range from price averaging to more complex functions based on volume and other measures. For example, Bollinger Bands are simply fixed percentages above and below a moving average. This mathematical function provides a clear price channel showing support and resistance levels.

Hybrid Indicator Components

Hybrid indicators use a combination of existing indicators and can be considered as simplistic trading systems. There are countless ways to combine items to form valid indicators. Here’s an example of the MA crossover:

This hybrid indicator uses several different indicators, including three instances of the moving averages. The three-, seven-, and 20-day moving averages should first be drawn based on price history. Then the rule looks for a crossover to buy the security or a crossover to sell. This system indicates a level at which a price movement can be expected and provides a reasonable way to estimate when it will occur (as the lines get closer). This is how it might look like:

A moving average crossover.
Image by Sabrina Jiang © Investopedia 2020

Create an indicator

A trader can create an indicator by following several simple steps:

  1. Determine the type of indicator you want to build: single or hybrid.
  2. Determine the components to include in your indicator.
  3. Create a set of rules (if necessary) to govern when and where price movements are expected to occur.
  4. Test your indicator in the real market by backtesting or paper trading.
  5. If it produces good yields, put it to use.

An example

Suppose we want to create an indicator that measures one of the most basic elements of the markets: price movements. The objective of our indicator is to predict future price movements based on this oscillation pattern.

Step 1:

We seek to develop a single indicator using two core elements, a pattern and mathematical functions.

Step 2:

Looking at the weekly charts of XYZ Company shares, we notice some basic swings between bullish and bearish that last for about five days. As our indicator is to measure price swings, we should be interested in patterns to define the swing and a mathematical function, price averages, to define the scope of these swings.

Step 3:

Now we need to define the rules that govern these elements. Patterns are the easiest to define – they are simply bullish and bearish patterns that alternate every five days or so. To create an average, we take a sample of the duration of the uptrends and a sample of the duration of the downtrends. Our end result should be an expected period of time for these movements to occur. To define the scope of the swings, we use a relatively high and a relatively low value, and set them to the high and low of the weekly chart. Next, to create a projection of the current incline / decline based on past inclines / declines, we simply average the total inclines / declines and predict that the same measured movements (+/-) will occur in the future. The direction and duration of the movement, again, is determined by the pattern.

Step 4:

We take this strategy and test it manually, or we use software to plot it and create signals. We found that you can successfully return 5% per swing (every five days).

Step 5:

Finally, we live by this concept and operate with real money.

Bottom line

Building your own indicator involves delving into technical analysis and then developing these building blocks into something unique. Ultimately, the goal is to gain an advantage over other operators. Just look at Ralph Nelson Elliott or WD Gann. Their successful indicators gave them not only a business advantage, but also popularity and notoriety within financial circles around the world.

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Mark Holland

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