How do you choose which indicators to use?

The choice of indicator depends on what you are trying to measure. Momentum is best measured with momentum oscillators like Rate-of-Change and MACD. Overbought/oversold levels are best measured with banded oscillators like Stochastics and RSI. Money flow is best measured with volume-based indicators such as On Balance Volume and the Accumulation Distribution Line. Trend is best measured with trend-following indicators like moving averages and Kelter Channels. Volatility is best measured by using Standard Deviation or Average True Range. There are even a few hybrids that combine factors. MACD combines trend following and momentum by measuring the difference of two moving averages. The Chaikin Oscillator adds momentum to the Accumulation Distribution Line.

It is important to avoid mulitcolinearity when using indicators. In other words, do not duplicate your efforts by using indicators that measure the same thing. RSI, CCI, MACD and Stochastics are all momentum oscillators that are highly correlated. It is not necessary to use all four to measure momentum. All four will rise when momentum is bullish and fall when momentum is bearish. Give them all a try, but try to focus on one or two when analyzing charts. If you favor trend, then perhaps MACD is best suited. If you favor overbought/oversold readings, then perhaps CCI fits best. It boils down to a personal preference. The chart below shows RSI, CCI and ROC moving up and down together.

Timeframe is also important when using adjustable indicators. On Balance Volume and the Accumulation Distribution Line are cumulative indicators that are not adjustable. One size fits all. However, most indicators are adjustable. Traders focusing on shorter time frames require shorter settings. Investors focusing on longer time frames require longer settings. The chart below shows Amazon with the 10-day SMA and 100-day SMA. The 100-day SMA was touched once, but the 10-day SMA was crossed numerous times. Also notice the different Stochastic Oscillators. The 14-day Stochastic Oscillator (green) became oversold four times in the last four months, but the 28-day Stochastic Oscillator (red) became oversold one twice.

by Arthur Hill