Weighting your trading signals

Weighting your trading signals to improve performance

One strategy I’ve considered while designing forex trading signals is assigning a weight to each signal based on its overall performance in predicting market movements. Just as a weighted moving average assigns greater importance to more recent price data with the goal of improving its predictive accuracy, weighted signals would gain or lose importance versus other signals based on certain types of performance data.

In a trading system that relies on several different signals, weighting could help decide between conflicting signals and make trading predictions clearer, removing some of the confusion and uncertainty that are deadly to successful forex trading. Let’s say you had a signal based on departure from a lower Bollinger Band that was shouting “Go long,” and another signal based on long-term moving averages that was insisting, “Stay short”! Which one should you listen to? It’s an ideal situation for signal weighting.

Bollinger Bands

So, how would you go about weighting your signals in a way that’s simple, easily understood, and most important, profitable? The best idea I’ve come up with so far is to determine the weight for each signal by calculating the average gain in pips for every trade it predicts. So maybe your long Bollinger Band signal historically yields an average gain of 10 pips per trade, while your short moving average signal yields 15 pips per trade. So, in theory, you could calculate that the moving average signal has 1.5 times the weight of the Bollinger signal, and therefore is the signal to follow.

When you’re combining multiple signals to determine a trade direction, weighting can also help by giving you a total score based on the combined signals. Let’s say you have three long signals with weights of 1, 1.5, and 3, and three short signals with weights of 1, 2, and 2. Adding up the long signals and then dividing by three for the average weight, you get a weighted score of 1.833, while your average score for the short signals is 1.667. So based on this technique, it looks like you should go long.

Another approach using weighted signals would be strictly additive – say you have 5 long signals adding up to a score of 8.5, and 3 short signals adding up to 10. While you’ve got fewer total short signals, they carry greater weight than the long ones, and so they win the trade.

These are just a few possible approaches to creating and interpreting your weighted signals. The key to determining the best weighting technique for your particular trading signals will be to test, test, and test some more using as much historical market data as you can get your hands on. Signals aweigh!

 

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