How to build a trading indicator

Elliott and Gann have become household names in the global trading community. These pioneers of technical analysis developed some of the most widely used techniques in the field. But how did Ralph Nelson Elliott and W. D. Gann come up with these methods, and why were they so successful? The truth is, it's not as difficult as it seems! This article will walk you through the process of creating your own custom indicator that you can use to gain an edge over your competitors.

Background

Recall that the theory behind technical analysis states that financial charts take everything into account, that is, all fundamental and environmental factors. The theory further states that these charts display elements of psychology that can be interpreted through technical indicators.

To understand this better, let's look at an example. Fibonacci retracements are derived from the mathematical sequence: 1, 1, 2, 3, 5, 8, 13 and so on. We see that the current number is the sum of the previous two numbers. What does this have to do with markets? Well, it turns out that these retracement levels (33%, 50%, 66%) influence traders' decisions to such an extent that these levels have become a set of psychological support and resistance levels. The idea is that by finding these points on the charts, future price directions can be predicted.

Indicator components

All indicators are designed to predict the direction of price movement given a certain condition. Traders try to predict two main things:

• Support and resistance levels: This is important because these are areas where prices change direction.
• Time: This is important because you need to be able to predict When there will be a price movement.

Sometimes indicators predict these two factors directly – as is the case with Bollinger Bands or Elliott Waves – but indicators usually have a set of rules set up to produce a forecast.

For example, when using the latitude indicator (which is represented by a line indicating momentum levels), we need to know which levels are relevant. The indicator itself is just a line. The breadth indicator is similar to the RSI in that it is “range bounded” and is used to measure the momentum of price movements. When the line is in the middle zone, the impulse is small. When it rises into the upper zone, we know that the momentum increases, and vice versa. You can go long when momentum rises from low levels and go short after momentum peaks at a high level. It is important to establish rules for interpreting the meaning of indicator movements in order to make them useful.

With that in mind, let's look at ways to create forecasts. There are two main types of indicators: unique indicators and hybrid indicators. Unique indicators can be developed using only the basic elements of chart analysis, while hybrid indicators can use a combination of the basic elements and existing indicators.

Components of unique indicators

Unique indicators are based on integral aspects of charts and mathematical functions. Here are the two most common components:

1. Patterns

Patterns are simply repeating sequences of prices observed over a period of time. Many indicators use patterns to represent likely future price movements. For example, Elliott wave theory is based on the assumption that all prices move in a specific pattern, which is simplified in the following example:

There are many other simple patterns that traders use to identify areas of price movement within cycles. Some of them include triangles, wedges and rectangles.

These types of patterns can be identified on charts just by looking at them; however, computers offer a much faster way to complete this task. Computer applications and services provide the ability to automatically find such patterns.

2. Mathematical functions

Mathematical functions can range from price averaging to more complex functions based on volume and other metrics. For example, Bollinger Bands are simply fixed percentages above and below a moving average. This mathematical function provides a clear price channel showing support and resistance levels.

Components of hybrid indicators

Hybrid indicators use a combination of existing indicators and can be considered as simplified trading systems. There are countless ways to combine elements to form valid indicators. Here is an example of an MA crossover:

This hybrid indicator uses several different indicators, including three instances of moving averages. First, you need to construct three-, seven-, and 20-day moving averages based on price history. The rule then looks for an intersection to buy the security or an intersection to sell the security. This system indicates the level at which price can be expected to move and provides a smart way to estimate when this will happen (as the lines move closer together). Here's what it might look like:

Creating an indicator

A trader can create an indicator by following a few simple steps:

1. Determine the type of indicator you want to build: unique or hybrid.
2. Determine the components that will be included in your indicator.
3. Create a set of rules (if necessary) that define when and where to expect prices to move.
4. Test your indicator on the real market using backtesting or paper trading.
5. If it brings good profits, use it.

Example

Let's say we want to create an indicator that measures one of the most basic elements of the market: price fluctuations. The purpose of our indicator is to predict future price movements based on this fluctuation pattern.

Step 1:

We strive to develop a unique indicator using two main elements: a template and mathematical functions.

Step 2:

Looking at the weekly charts of XYZ Company stock, we notice some major swings between bullish and bearish sentiment, each lasting about five days. Since our indicator is designed to measure price fluctuations, we should be interested in the patterns that determine the fluctuations and the mathematical function, the average prices, to determine the magnitude of these fluctuations.

Step 3:

Now we need to define the rules that govern these elements. These patterns are the easiest to identify: they are simply bullish and bearish patterns that alternate every five days or so. To create the average, we take a sample of the duration of the uptrend and a sample of the duration of the downtrend. Our end result should be the expected time period for these movements to take place. To determine the size of the swing, we use the relative high and relative low and set them to the high and low of the weekly chart. Next, to create a forecast of a current advance/decline based on past advances/declines, we simply average the total advances/declines and predict that the same measured moves (+/-) will occur in the future. The direction and duration of movement are again determined by the pattern.

Step 4:

We take this strategy and test it manually or use software to plot it and create signals. We have found that it can successfully return 5% per swing (every five days).

Step 5:

Finally, we implement this concept and trade with real money.

Bottom line

Creating your own indicator involves going deeper into technical analysis and then turning those basic components into something unique. Ultimately, the goal is to gain an edge over other traders. Just look at Ralph Nelson Elliott or W.D. Ganna. Their successful performance has given them not only a trading advantage, but also popularity and fame in financial circles around the world.