Combining Indicators

One very common technique that traders use when working with indicators is combining more than one indicator into a trading system. For example, a trader might work with MACD on a regular basis and ADX as well. Both seem to work well in various market environments even amongst different lists of stocks. So, the trader decides that using both as filters would be a great way to find good trades. This rationale makes plenty of sense because it works with almost everything else in life like combining a relaxed swing with turning your hips in golf.

But don't be easily deceived. When I first started trading, I assumed just like many traders have that adding another good indicator would strengthen my trading system. But that assumption was not based on real stock market data. It was based on what LIFE taught me about putting 2 good things together. Later on, I tested 2 indicators that I liked and found that adding the second indicator actually made the system worse. It also shortened my list of potential buys as well. This brings to light even further insight, namely that although it may work to make assumptions quickly in life, it works very poorly in the stock market. Once you have your process down, it should only consist of techniques that have been tested or have real data to back them up. Not only that, it should be based on long term data. So be careful with the assumptions you make and only combine indicators if they have been tested together. We live in technology age, so we shouldn't have to rely on so many assumptions and hunches anymore when it comes to trading. Next let's look a widely held belief about volatility.

Volatility

Most option traders would rather trade a stock that has high volatility vs. low volatility. The rationale behind this thinking is that high volatility stocks move more than low ones and that this quality increases the chances of the stock going up (in the case of a call). Does that mean we should buy high volatility stocks? Remember that our object here is to make money. Stocks that have a high 20-day historical volatility tend to have higher prices all other things equal. With a higher cost basis, it's more difficult to profit on the option. So, if we have 2 options with everything equal between them and the underlying stocks on both options go from 50-60, there will be more profit on the low volatility stock because the cost basis was lower.

Here is a good way to deal with this. If you have 2 stocks that are almost exactly the same except one has a higher 20-day volatility than the other, choose the one with the less expensive time value portion of the option. For example, let's ABC stock has .55 volatility and the option is $2.00 in the money and costs $3. That means that the time value of this option is $1. XYZ stock on the other hand has a volatility of .12 and its option is also $2.00 in the money and costs $3.00 total. That means both options cost the same, but one has higher volatility. In this case, I would buy the stock with the higher volatility because the option is the same price anyway. Beware though that higher volatility does not mean a higher chance of being right on the trade. Higher volatility usually means that if you are right, you will make more money than you would have with low volatility.

So remember these 2 concepts for the future and profit from them:

• Be careful with assumptions and draw your conclusion instead from data
• If you want to buy a high volatility stock, pay attention to the price you pay.

Price Headley is the founder and chief analyst of BigTrends.com.