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 with a 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 average while interest 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. Or it 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 activity can 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.