A graphical approach to indicator testing
The first step in algorithmic strategy design usually is to find some indicators which give you an edge and tell you something about tomorrow’s market behaviour. You could use a lot of statistics to describe this edge, but I like to take a graphical approach in indicator testing first, and only later on worry about the maths and statistics.
A scatter chart is a simple to read chart style to see the correlation between two input values. A regression line on the scatter chart gives you a visual idea if the two securities are positively or negatively correlated, the “cloud structure” of the scatter points tell you if this correlation is tight or loose.
This sample scatter shows the correlation between the DAX and DOW levels, and it can be easily seen that these two markets are tightly correlated in a positively way.
The horizontal scale is used for the second security (DAX), the vertical scale is used for the first security (DOW). This chart type is predefined in Tradesignal, just drag&drop it onto the securities on the chart and select the right amount of data to get the analysis you want to see. (eg. 2000-now). If you see a tight and positive correlation like on the chart above, It might be used to select the instrument you want to trade. If market A is easier to predict than market B, select A.
Scatter on Indicators
Although a scatter chart is usually used to show the correlation between two markets, it can also be used to show the correlation between two indicators.
The chart above shows the correlation between digital stochastic and momentum. Have a look at the clustering of points in on the right side of the scatter, a high level in digital stochastic usually goes with a high momentum. This insight enables you to get rid of momentum, as digital stochastic is easier to read than the shaky momentum. Less indicators = less parameters = less curve fitting.
Doing this analysis and getting rid of parameters is great if you want to minimise the dangers of curve fitting, but it does not tell you if your indicator is of any use at all, when it come to describing tomorrows move of the market. Surely it is valuable insight that a high level of stochastics corresponds to a high momentum, but does a high momentum today also mean that the market will move up tomorrow? And this question about tomorrow is the key question I ask myself when searching for some edge.
To get a glimpse on the prognosis quality of an indicator we will have to add some colour to our scatter chart. This colour tells me what the market has done after a specific indicator level has been reached. Green for an up move, red for a down move, black for not decided by now.
This chart shows the prognosis quality of the stochastic indicator. The left chart shows the 1 day prognosis of a 5 day stochastic, the right chart gives you the 5 day prognosis of a 21 day stochastic. Observe the clustering of the red and green dots. (black for not decided by now) As you can see on the left chart, the one day prognosis using a 5 day stochastic is not the thing to do. Regardless if stochastic is high or low, you get a nice mixture of red and green dots. This means the market, at a given stochastic level, sometimes moved up, sometimes moved down. Not this behaviour is not very useful for trading. Only in the extreme, near 0 and 100, this indicator seems to implicate a bearish next day movement.
The right chart, showing the longer term prognosis of a long term stochastic seems to be more useful. High levels of the indicator also show positive returns on the 5 days after, unfortunately you can not reverse the logic, as low indicator levels give a rater mixed prognosis. This visual analysis can give you an idea which areas of the indicator might be useful for further analysis.
A one dimensional analysis like on the chart above could also be done without this scatter chart. Going from one dimension to two dimensions is more useful, as it directly can be translated to do a kNN machine learning trading strategy. Have a look at the following chart. It shows the scatter of two indicators and the implication on the next days market move.
Lets start with he right chart. As you can see the red and green dots are evenly distributed, meaning there is no useful correlation between the used indicators and the movement of the market on the day after. If you would use a kNN algorithm with these two indicators, I would bet it would not return great results. Even if you would get a positive return, it might just be a lucky hit or curve fitting.
The opposite is true for the chart on the left. Here you can see some nice clustering of the red and green dots. Low indicator levels seem to predict a bearish move, high indicator levels result in a bullish move on the next day. A distribution like this is the perfect starting point for investing some time in a kNN machine learning trading strategy. The kNN algorithm would give you a strong prognosis with high or low indicator levels, and most probably only a weak or no prognosis when the indicators are around 50. The returns will be stable, no curve fitting problems should be expected.
Using a scatter chart can give you a nice visual indication if your indicator might be useful for a prognosis of the next days market move. This is valuable insight, as you can see the whole data universe with one glimpse, even before you do a thoroughly statistical analysis. Numbers can deceive you, pictures usually tell the complete story.
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This article is highly correlated to the KNN machine learning article