Avoid Multicollinearity

A cardinal rule for the successful use of technical analysis requires avoiding multicollinearity amid indicators. Multicollinearity 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 (Bollinger on Bollinger Bands). Multicollinearity is a serious problem because collinear variables contribute redundant information and can cause other variables to appear to be less important than they really are.

The best way to quickly determine if an indicator is collinear with another one is to chart it. Make sure you have enough data on the chart to get a good indication. If they basically rise and fall in about the same areas, the odds are that they are collinear and you should just use one of them.

Based on my research, I have arranged technical indicators into two categories to keep from using too many from the same category.

Momentum

Trend

· Moving Average Convergence Divergence (MACD)

· Rate of Change (ROC)

· Stochastics (%K, %D)

· Relative Strength Index (RSI)

· Commodity Channel Index (CCI)

· Williams %R (Wm%R)

· StochRSI

· TRIX

· Ultimate Oscillator (ULT)

· Aroon

· Moving Averages

· Average True Range (ATR)

· Wilder’s DMI (ADX)

· Price Oscillator (PPO)

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