1. Introduction to indicators
Welcome to the third chapter, indicators.
2. Why use indicators?
To motivate this chapter, the salient point to keep in mind is that market data is noisy, messy, and generally, prone to toying with systems and emotions alike.
3. What are indicators?
In order to try and make sense of this data, trading systems employ indicators, which are transformations of data that make some sort of tradeoff. Usually, this tradeoff is lag for smoothness. An indicator attempts to paint a clearer picture of what occurs in the price movement of the asset under analysis, but pays for it by needing to look at past data, which means that it might not react quickly to sudden developments. Better-designed indicators try to get more smoothness without sacrificing responsiveness.
4. Indicator examples
Neverteheless, there are some fairly famous indicators. The 200-day simple moving average is a filter, or more colloquially, a trend indicator that is the basic average of the past two hundred days, usually of the closing prices. Its purpose is to work as a slow moving average that signals an expectation of rising prices when some faster metric is above it, such as closing prices, a 50-day moving average, and so on.
5. Indicator examples
Another type of famous indicator is the relative strength index, or RSI, that's an oscillating indicator. The RSI, and other oscillating indicators like it, do not take values on the scale of the price of the original asset, but instead take values between 0 to 100, 0 to 1, or values that are centered around zero. Many times, the purpose of such oscillating indicators is to use a short lookback to predict when a price has temporarily decreased and is predicted to increase over the next several days.
Between systems that may depend on short-term oscillation indicators like a 2-day relative-strength index, to very long-term trading systems such as a dual moving average crossover system, indicators can create a multitude of strategies.
6. In this class
The strategy we will analyze in this class will be one that combines a basic moving average crossover as a filter with an oscillation indicator to enter positions.
Furthermore, the oscillator you will develop for this class is not found in any R package, proving that you can develop your own indicators, so long as you have the imagination for it.
7. Let's practice!
Good luck!