Strength of Signal – An Important Consideration for Traders?

In this article, we take an in-depth look at the concept of strength of signal and its potential role in improving trading outcomes. Traders are constantly seeking ways to enhance their results consistently, and the idea of evaluating the strength of a trading signal may provide a pathway toward greater reliability and performance when applied to trading systems across multiple timeframes and instruments.

By delving into this concept, we will explore not only what strength of signal means but also the key factors involved in its practical application in decision-making and trade execution.

Why Could Strength of Signal Be Important for Traders?

Definition: Strength of signal refers to the degree of confidence and reliability a particular trading signal provides regarding anticipated market movements. It measures the quality and trustworthiness of a trading setup, aiming to increase the likelihood of success by filtering out weaker signals and focusing on higher-probability opportunities.

The idea of strength of signal is most commonly applied to trade entries, where traders seek to increase their chances of entering the market at an optimal point. This can lead to better overall performance by avoiding premature or low-confidence entries that could result in losing trades.

However, strength of signal also holds significance in trade exits. For instance, a strong signal at the entry point may weaken over time, indicating a lack of continuation in the trend. This change in signal strength could provide the trader with an early warning to exit the trade before a reversal occurs.

At its most basic application, strength of signal may help traders decide whether to enter a trade. However, its implications are far-reaching, influencing other critical aspects of trading such as:

• Position sizing: When the signal is stronger, a trader may feel more confident about increasing their position size. A weak signal, on the other hand, may prompt the trader to either reduce their position size or avoid entering the trade entirely.
• Accumulating positions: If a trader has already entered a trade and the strength of the signal improves, they might decide to add to the existing position. This practice, known as scaling in, can maximize gains during favourable market conditions.
• Exit decisions: Weakening signal strength can serve as a warning sign to exit a position. If a trade was initially based on a strong signal but the factors driving that signal begin to diminish, it could indicate a shift in market sentiment, prompting the trader to take profits or cut losses.

Components of Strength of Signal

The strength of a signal can be broken down into three broad categories: price action, trading volume, and the confluence of technical indicators. Each of these components contributes in its own way to the overall reliability of the trading signal.

a. Price Action
Price action is the cornerstone of technical analysis and is considered the most important component when assessing the strength of a signal. This is because price action reflects real-time market sentiment and behaviour.

• Candle structure: The open, high, low, and close (OHLC) of a candlestick offers vital clues about the current battle between buyers and sellers. For example, long wicks might indicate rejection of certain price levels, while a series of bullish or bearish candles can point to the start of a trend.
• Patterns and formations: Multiple candlesticks forming patterns (e.g., head and shoulders, triangles, or flags) can provide insight into potential reversals or continuations. Recognizing these patterns can significantly contribute to assessing signal strength.
• Timeframe comparison: Price action can vary significantly across different timeframes. A signal that appears strong on a lower timeframe, such as a 5-minute chart, might weaken when compared to the price action on a daily or weekly chart. Evaluating the signal across multiple timeframes helps traders confirm its validity.
• Key levels: Price action near key levels, such as support and resistance or pivot levels, play a crucial role in signal strength. The closer the market is to a critical level, the more likely a strong reaction will occur, either a bounce or a break, adding weight to the signal.

b. Trading Volume
Volume is another critical component of strength of signal, as it represents the number of shares, contracts, or lots being traded at a particular price. Volume provides insight into the level of market participation and the conviction behind price movements.

• Volume confirmation: When volume increases in the direction of the price move, it signals strong market participation, adding confidence to the strength of the signal. A price movement without sufficient volume may be viewed with caution, as it could lack the momentum needed for continuation.
• Volume divergence: Divergence between price and volume can signal a weakening trend. For instance, if prices are rising but volume is decreasing, it may indicate that the buying interest is waning, and the strength of the signal is diminishing.
• Volume spikes: Sudden spikes in volume can indicate institutional participation or a major market event. High-volume candles at key levels can often confirm the validity of a breakout or breakdown.

c. Other Indicator Confluence
Technical indicators summarize historical price and volume data, and while they are lagging in nature, they are undoubtedly useful in adding an additional layer of confirmation to any signal evaluation.

• Commonly used indicators: Many traders rely on widely recognized indicators such as moving averages, RSI, MACD, or ATR. These indicators help identify trends, momentum, volatility, and potential reversals. The alignment of multiple indicators—often referred to as confluence—can significantly strengthen a signal.
• Categories of indicators:
  • Trend indicators: Tools such as moving averages and parabolic SAR can help traders identify the overall direction of the market. A trade that aligns with the prevailing trend is likely to have a stronger signal.
  • Momentum indicators: Indicators like RSI and MACD provide insight into the speed of the price movement. A weakening momentum might indicate that a trend is losing steam, reducing the signal’s strength.
  • Volatility indicators: Tools like ATR measure the degree of price fluctuation. Sudden changes in volatility can affect signal strength, as low volatility periods may precede explosive movements.
  • Mean reversion indicators: Bollinger Bands and similar indicators help traders identify overbought or oversold conditions. Trades taken at the extremes of these indicators can have stronger signals if supported by price action and volume.

The Role of News and Events as an influence on strength of signal evaluation

Event risk is a crucial, yet often underestimated, component of signal strength. No matter how strong a technical signal appears, the release of major economic data or geopolitical news can drastically alter market conditions, leading to unexpected price movements.

It’s essential for traders to remain aware of scheduled news events, such as central bank meetings or earnings reports, which can cause sudden volatility. A strong technical signal might be overridden by fundamental factors, so incorporating event risk into the overall assessment of signal strength is a necessary practice.

The Case for Weighting and a Strength of Signal Score

To make the assessment of signal strength more objective, traders can develop a weighted scoring system. By assigning a value to each component (price action, volume, indicators, etc.), they can generate a Strength of Signal (SOS) score. This score provides a quantitative measure to guide trading decisions.

• Weighting components: Not all factors carry equal importance. For instance, price action may be assigned a higher weight than indicator confluence, as it reflects current sentiment. A possible weighting system could look like this:
  • Sentiment change: 40%
  • Candle structure: 20%
  • Higher timeframe confirmation: 10%
  • Volume: 10%
  • Proximity to key levels: 10%
  • Momentum: 5%
  • Volatility change: 5%
• Instrument and timeframe differentiation: Different instruments and timeframes may require tailored weighting. For example, the weighting system for a fast-moving 30-minute gold chart might differ significantly from that of a more stable 4-hour AUD/NZD chart.

Using a Score to Drive Trading Decisions

Once a strength of signal score is established, it can be applied to various aspects of trade management:

• Entry decisions: A minimum SOS score (e.g., 60) could be required for entering a trade. This ensures that only high-quality setups are considered.
• Position sizing: A higher SOS score could justify increasing position size. For example, if the score is above 70, a trader might increase their position by 1.5x the normal size, while a score above 80 might warrant doubling the position.
• Exit decisions: A decreasing SOS score (e.g., below 30) might signal the need to exit the trade, helping traders protect profits or minimize losses.

Summary

The concept of strength of signal offers a structured approach to assessing the quality of trading setups. By incorporating factors like price action, volume, and technical indicators into a weighted system, traders can make more informed decisions, potentially improving both their consistency and performance.

Experimenting with different scoring systems and analysing their impact on your trading strategy is worthwhile investigating further in the reality of your own trading. Over time, a well-developed score can provide valuable insights into when to enter, accumulate, or exit trades based on the changing dynamics of the market.