Saturday, November 18, 2006

Beware Multicollinearity!

I was reading the tutorial, and the page about multicollinearity really caught my attention:
A cardinal rule for the successful use of technical analysis requires avoiding multicolinearity amid indicators. Multicolinearity is simply the multiple counting of the same information. The use of four different indicators all derived from the same series of closing prices to confirm each other is a perfect example.

So one indicator derived from closing prices, another from volume and the last from price range would provide a useful group of indicators. But combining RSI, moving average convergence/divergence (MACD) and rate of change (assuming all were derived from closing prices and used similar time spans) would not.
He goes on to explain that RSI, On Balance Volume, and Money Flow make a good combination for avoiding multicollinearity. also has an article on multicollinearity. says their trading signals are carefully chosen to avoid multicollinearity. Their studies combine the following:
  • Intermediate, 1 month and short-term trend lines
  • Overbought/sold indicators
  • Direction of last trade
  • Candlesticks patterns
  • Money Flow
  • On Balance Volume
  • Support and Resistance
  • Gaps and Spikes
  • Relative Strength vs. market
  • Relative Strength vs. industry
  • Industry trend
Personally, I've been gravitating toward using:
  • ADX/DMI for trend
  • Support and resistance
  • Price patterns - especially new highs breaking out of consolidations
  • Candlesticks
  • Stochastics
and applying them to daily and weekly charts.

After reading the article, I'm noticeably missing is some kind of volume indicator. Normally I just eyeball the volume, looking for a volume surge to back the entry signal provided by the other indicators. But now I'm thinking that adding Chaikin Money Flow or On Balance Volume would make it more systematic.


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