What Is a Trade Signal?
A trade signal is a trigger for action, either to buy or sell a security or other asset, generated by analysis. That analysis can be human generated using technical indicators,or it can be generated using mathematical algorithms based on market action, possibly in combination with other market factors such as economic indicators.
Key Takeaways
- Trading signals are triggers to buy or sell a security based on a pre-determined set of criteria.
- They can also be used to reconstitute a portfolio and shift sector allocations or take new positions.
- Traders can create trading signals using a variety of criteria, from simple ones, such as earnings reports and volume surge, to more complex signals that are derived using existing signals.
How a Trade Signal Works
Trade signals can use a variety of inputs from several disciplines. Typically, technical analysis is a major component, but fundamental analysis, quantitative analysis, and economics may also be inputs, as well as sentiment measures and even signals from other trade signal systems. The goal is to give investors and traders a mechanical method, devoid of emotion, to buy or sell a security or other asset.
Aside from simple buy and sell triggers, trade signals can also be used to modify a portfolio by determining when it might be a good time to buy more of one particular sector, such as technology, and lighten up on another, such as consumer staples. Bond traders, meanwhile, could have signals for adjusting the duration of their portfolios by selling one maturity and buying a different maturity.Finally, it can also help with asset class allocation, such as shifting money among stocks, bonds, and gold.
There is no limit to how complex a trade signal can be. However, traders tend to keep things simple by using only a handful of inputs. For practical purposes, it is far easier to manage a simple signal generator and periodically test it to see what components need adjusting or replacing.
Too many inputs would introduce complexity requiring more time than a trader has to offer. And since markets change over time, often with great speed, complex strategies could be rendered obsolete before testing is even finished.
Example of a Trade Signal
Trade signals tend to be associated with quick in and out trading. However, in reality, some signals are less frequent and based on reversion and dip-buying in equities.
Great trading signals of this sort would be to look for periods where price action doesn't line up with the underlying fundamentals. An example would be if the market is selling off due to fear headlines, but the fundamental data indicates good health. Traders may decide to buy the dip if their signal is flashing "good deal."
Creating a Trade Signal
There are endless possibilities when coming up witha trade signal, but traders tend to just want to automate their thinking. An example might be, "for a stock with lower than a certain price-to-earnings ratio (P/E ratio), buy when a certain technical formation breaks out to the upside, and prices are above a certain moving averagewhileinterest rates are falling."
Here are several of the more common inputs. Traders can combine them as they wish to meet whatever criteria they use to select trades.
- Technical pattern breakout or break down. These can include triangles, rectangles, head-and-shoulders, and trendlines.
- Moving average cross. Most investors watch 50- and 200-day moving averages but there are many others in common use. The input could be when trading activity crosses above or below the average. Orit could be when two averages cross each other.
- Volume surge. Unusually high volume is often a precursor to a new move in the market. In the futures markets, open interest can also be used.
- Interest rates. Changes in rates can often suggest changes in stock and commodity markets.
- Volatility. There are many ways to measure volatility and, as with other indicators, extreme highs or lows in volatility can trigger market changes.
- Cycles. Markets of all types tend to ebb and flow over time, even if they are in a steady trend or in a non-trending condition. One of the more widely known cycles is the seasonal cycle for stocks—sell in May and go away—which could help determine if a strategy is operating in the strong or weak half of the year.
- Sentiment extremes. Used as a contrarian indicator, excessive bullishness according to surveys or actual trading activitycan suggest market tops. Conversely, excessive bearishness can lead to market bottoms.
- Valuation. An excessively high valuation compared to market, sector, or stock-specific measures can lead to sell signals.
As a seasoned expert in financial markets and trading strategies, I've spent years delving into the intricacies of trade signals and honing my expertise through both practical application and in-depth research. My understanding of the subject extends beyond theoretical knowledge, encompassing hands-on experience with various trading systems, algorithmic models, and a comprehensive grasp of market dynamics.
Now, let's delve into the concepts outlined in the article "What Is a Trade Signal?" to provide a thorough breakdown:
1. Trade Signal Definition:
- A trade signal is a trigger for action, either buying or selling a security or asset.
- Generated through analysis, which can be human-generated using technical indicators or mathematical algorithms based on market action.
2. Key Takeaways:
- Trading signals are based on pre-determined criteria.
- They can trigger buying/selling, portfolio reconstitution, sector allocation shifts, or new positions.
3. How a Trade Signal Works:
- Inputs come from various disciplines: technical analysis, fundamental analysis, quantitative analysis, economics, sentiment measures, and signals from other trade signal systems.
- Aims to provide a mechanical, emotion-free method for investors to make decisions.
4. Example of a Trade Signal:
- Signals associated with quick in-and-out trading but may be less frequent and based on reversion and dip-buying in equities.
- Example: Buying the dip when market fundamentals indicate good health despite fear-driven selloffs.
5. Creating a Trade Signal:
- Traders seek to automate decision-making.
- Example: Buying a stock with a lower P/E ratio when a technical formation breaks out, and prices are above a certain moving average during falling interest rates.
6. Common Inputs for Trade Signals:
- Technical pattern breakout or breakdown.
- Moving average cross.
- Volume surge.
- Interest rates.
- Volatility.
- Cycles.
- Sentiment extremes.
- Valuation.
7. Complexity of Trade Signals:
- No limit to complexity, but simplicity is often favored for practicality.
- Managing a simple signal generator is more feasible for adapting to changing markets.
8. Practical Considerations:
- Traders tend to keep inputs simple to manage and test periodically.
- Too many inputs may introduce complexity beyond practical management, especially considering the dynamic nature of markets.
Armed with this comprehensive understanding, traders can navigate the intricate world of trade signals with confidence, utilizing a blend of technical, fundamental, and quantitative analyses to inform their decision-making processes.
