Signal saturation: a good problem to have. (Or, what to do with your overlapping signals)

I don't even know if I'd call this a problem - it's more of a confirmation that you're on the right track with your trading system. What I mean by signal saturation is when you add new and promising signals to your trading system, but they don't add much to the bottom line. I had this problem today with the Ichimoku indicators discussed over at Forex Project. Intrigued by their possibilities, I wrote up a few Ichimoku equations and backtested them on some EUR/USD data, and came up with what looked like excellent results. But then I plugged my new Ichimoku signals into my trading system, ran the same backtests and found they added only a few new pips to the results - and in a couple configurations, actually subtracted pips!

What's going on here? Well, it's a problem I encounter most of the time when trying to introduce new signals to my system: the existing signals are already covering that territory, so there's no additional trading edge to be gained. Or, to put it in a more positive light, the new signals are simply confirming the validity of your existing signals, since they overlap with them almost completely. Having two sets of signals that are saying the same thing certainly suggests you're doing something right. When I come across this type of signal saturation or overlap, I will usually just put the redundant signal in storage with my other backup systems, in case market conditions change someday and it's no longer redundant.

Another strategy for dealing with overlapping signals is interpret them as reinforcing each other: if two or more signals are in play, it's an even stronger trading indicator than one signal. So it's possible that the combination indicates an even higher-probability trade than a single signal, something you'll want to test out by statistically comparing the outcomes of single signal vs. multi-signal trades.

Yet another weird quirk of overlapping signals are the areas where they don't overlap. There are sometimes significant opportunities to be found in the 10% of disagreement between signals that agree 90% of the time. For example, some of my most powerful short signals are generated when two of my highly-correlated long signals part ways. For whatever reason, at these points of disagreement, the market tends to go the other way entirely and what's usually a long signal becomes a short one. One example I mentioned above is when those Ichimoku indicators were actually subtracting pips from my long trades.

You can get caught up in all kinds of explanations for why this happens, most of which will lead you nowhere - but the important thing is it happens. (But if you really want an explanation my personal theory is it's a form of divergence.)

So, to summarize: in the worst case, signal saturation is a minor annoyance. In the best case, it's a way to generate even stronger signals, and even some unusual new signals. If it shows up in your trading system, congratulations, you're on the right track!

Related topic:
Signals aren't set in stone...so don't be afraid to fine-tune them