Combining Trend and Oscillator Signals by Jeremy G. Konsten
Most trading systems fall into two categories. One, the most popular, is the trend-following method, where the signals are oriented toward putting the trader on board long-term trends. The profits acquired during the long-term trends will, hopefully, recover the monies lost during trendless activity. The other category takes advantage of trading ranges, and the trader makes the most money when the market's primary direction is sideways. Here's a trading system that incorporates both approaches to time entry and exit positions.
Market technicians looking to pinpoint market tops and bottoms have long been fascinated by the cyclical activity of markets. The oscillator, which is the class of indicators used to model the cyclical nature of markets, typically will filter the trend out of prices, leaving only the tradable cycles. In addition, an oscillator is a type of momentum indicator that shows the acceleration and deceleration of markets. When a market has been accelerating upward and then begins to slow, the oscillator levels off, indicating the price action as a market top. Likewise, if a market is accelerating downward and that acceleration slows, then a bottom is indicated by the oscillator leveling off and then rising.
The danger of oscillators is that they will register the same level of peak momentum day after day or week after week, which would indicate a top or bottom when in reality the market is simply in a long-term bull or bear market. As you can imagine, many traders have lost money by mechanically following an oscillator-based model. Premature signals falsely indicating a short position in a market in a strong uptrend or a long position in a market in a strong downtrend can lead to persistent losses. Often, the losses will compel the trader to research trend-following methods.
During a trending market, a trend-following indicator will perform better than any other indicator because the signals are designed to put the trader on the correct side of long-term trends. A simple example is the simple moving average (SMA), which smoothes out the daily fluctuations, considered to be noise, and as long as the market price stays above the rising moving average, an uptrend is in force. But during a trendless or sideways market, a series of losing trades occurs.
During such a period, each new signal leads to losses. This can happen to all trend-following models and result in significant drawdowns. My proposal, then, is to combine two indicators, an oscillator and a simple moving average system, into one trading system. The goal is to cancel out the negative properties of the individual approaches and integrate their strengths.