When building a forex trading system, make sure not to use very similar trading indicators on the same chart timeframe because you will collect the same type of technical information more than once and very often, this will lead to bad trading results. Multicollinearity is a high degree of correlation between the indicators simply means using the multiple counting of the same information.
Example using RSI with Stochastics where the same data information is used more than once, whereby collinear indicators are not giving you any valuable additional information but are misleading. A lot of currency traders are guilty of thinking if we add more indicators to the charts, it would make us more money but most really successful traders use very simple systems. Keep it simple and select your indicators very carefully to avoid the multicollinearity trap!
Basically, technical indicators used in forex trading systems can be arranged in four main categories:
Momentum Oscillators
Trend - Following
Trend - Confirming
Volume
Indicator Category
Most Important Indicators
Momentum Oscillators
Relative Strength Index (RSI)
Commodity Channel Index
Williams %R Oscillator
Stochastic oscillator
Momentum Average True Range (ATR)
Trend - Following
Moving Averages Bollinger Bands Wilder's DMI Index
Trend - Confirming
Moving Average Convergence/Divergence (MACD)
Wilder's ADX index
Parabolic Sar
Volume
Accumulation Distribution
On Balance Volume (OBV)
Money Flow Index
Chart your trading system and avoid the multicollinearity trap.
The best way to discover if an indicator is collinear with another one is to add them to a chart. If they rise, fall, make bottoms and tops in about the same locations, probably, they are collinear and you should remove one of them to make sure your indicators don't play the same song.
Chart examples:
1) Collinear indicators example:
Both CCI and Stoch indicators show very similar signals on the chart and are basically saying the same story, they are collinear and you should remove one of them because collinear indicators are not giving you any valuable additional information.
2) Not collinear indicators example:
Below example shows two indicators that are non-collinear because they don't rise, fall, make bottoms and tops in about the same area's. Both can give valuable information for the forex trader.
