Assessing Indicator Effectiveness

Overview

Technical analysis is a type of asset analysis that focuses on price and volume data. Traditionallly, technical analysis was done by plotting various indicators on a chart, and the analyst interpreting the presented information.

After some time, the methods of statistical analysis and computing provided tools for assessing how effective a given indicator (or set of indicators) is at forecasting performance.

Methods

• Backtesting : is one of the standard ways to test indicator effectiveness. In a backtest, we construct an algorithm that would simulate a trading strategy based on the indicator in question. If the trading strategy would have beaten the market, we take this as evidence that the indicator has some effectiveness to it.
  
  Backtesting has some down sides though. While it may indicate whether you could have done well in the past, it does not in general provide any type of statistical confidence. To do this requires doing some type of statistical tests as below.
• Statistical Tests - provide a method of estimating numerical likelihoods that can give a better foundation for confidence in an indicator