Multicollinearity
A look at how to avoid having two very similar signals on the same chart and the importance of doing so.
What Is Multicollinearity?
Multicollinearity is a statistical term referring to the unknowing use of the same type of information more than once. It is a common problem in technical analysis. Analysts need to be careful not to utilize technical indicators that reveal the same type of information.
Here is how John Bollinger puts it: “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.”
Multicollinearity is a serious issue in technical analysis when your money is at stake. It is a problem because collinear variables contribute redundant information and can cause other variables to appear to be less important than they are. One of the real problems is that, oftentimes, multicollinearity is difficult to spot.
Indicators From Different Categories
Technical indicators should be arranged in categories to avoid using too many from the same category. Below is a table that categorizes the indicators available at StockCharts.com.
| Category | Indicators | |
|---|---|---|
Momentum | ||
Trend | ||
Volume | Chaikin Money Flow (CMF) Volume Rate of Change Volume Oscillator (PVO) Demand Index On Balance Volume (OBV) Money Flow Index |
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 rise and fall in the same areas, the odds are that they're collinear and you should just use one of them.
The first chart below shows some examples of indicators that are collinear. Notice that all three indicators are basically saying the same thing. If your analysis was that this was supportive information, you would be falling into the multicollinearity trap. Pick one of the indicators for your analysis and do not use the others.
Below are some examples of indicators that are not collinear. When interpreted correctly, each will give different information. The indicators can be used to confirm a trading signal.
The Takeaway
If you are randomly selecting indicators to support your analysis, you will more than likely fall into the multicollinearity trap of using multiple indicators that are all saying the same thing. They are not giving you any additional information; in fact, they are restricting your overall view of the market. Don't search for supporting information among collinear indicators; though they can be appealing, they are ultimately misleading.
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