What it means
Instead of trading on gut feeling, many investors define in advance what has to happen before they act. A trade signal is the output of such a rule, for example "buy when the short-term average price rises above the long-term average".
Signals can be technical, which means they come from patterns in price and volume. Common examples include moving average crossovers, a security breaking above a recent high, or an indicator such as the relative strength index (a measure of how fast and how far a price has moved) showing that a price has become stretched.
Signals can also be fundamental or event driven, such as a company reporting earnings above expectations, a change in a credit rating or a shift in interest rates. Quantitative funds combine many such inputs into scores and trade automatically when the score crosses a threshold.
The value of a signal lies in discipline and testing. A well-defined signal can be tested against past data, a process called backtesting, to see how it would have performed, which helps an investor judge whether it is worth using, and removes some of the emotion from decisions.
Signals are not predictions or guarantees. Many are wrong, markets change, and a rule that worked in the past can stop working, so sensible users combine signals with risk controls such as position limits and stop losses, and account for trading costs and taxes.
For a finance manager who is not a trader, the term still appears in treasury and corporate pension discussions. Teams may use signals to decide when to hedge currency exposure or rebalance a portfolio, and the lesson is to understand the rule behind any signal before acting on it.
In practice
Real-world examples.
Example
A trader uses a rule that says to buy a share when it closes above its highest price of the last 50 days. The share closes at $42.10 against a previous high of $41.80, so the rule generates a buy signal.
Example
A corporate treasurer sets a rule to hedge half of a euro receivable when the exchange rate falls below a set level. When the rate crosses the level, the treasury system sends an alert, and the treasurer places the hedge.
Example
A quantitative fund scores 500 shares each night on value, momentum and quality. Shares with scores above a threshold generate buy signals and the portfolio is adjusted the next morning.
Formula
Calculation
Buy signal when the short-term moving average crosses above the long-term moving average
Suppose a share closes at $51, $50, $49, $48, $50 and $53 over six consecutive days. Yesterday, the 3-day average of the last three closes (49, 48, 50) = 147 / 3 = $49.00, and the 5-day average of the last five closes (51, 50, 49, 48, 50) = 248 / 5 = $49.60. The short average was below the long average. Today, the 3-day average (48, 50, 53) = 151 / 3 = $50.33 and the 5-day average (50, 49, 48, 50, 53) = 250 / 5 = $50.00, so the short average has crossed above the long average and a buy signal is generated.Case study
Seen in the real world.
Quayside Partners is an illustrative, fictional small investment firm that managed $20,000,000 and was testing a moving average crossover signal on a stock index fund. The analyst backtested the rule on ten years of data and found that it reduced the worst fall in the portfolio from 30% to 18%.
However, the rule also produced 24 trades a year, and each round trip cost 0.1% in dealing costs and spreads. On $20,000,000 and 24 trades, the cost was roughly 24 x 0.001 x 20,000,000 = $480,000 a year if the whole portfolio were traded each time, which was a large drag on returns.
The firm adjusted the rule so that it traded only on stronger crossovers and cut the number of trades to 8 a year. The illustrative lesson is that a signal should always be judged after costs, and that fewer, clearer signals are often better than many weak ones.
Watch out
Common mistakes.
- Treating a signal as a certain prediction, when every rule gives some false alarms and losing trades.
- Testing a signal only on the data used to design it, which tends to make it look better than it will be in real trading.
- Ignoring trading costs, taxes and slippage, which can turn a profitable signal on paper into a loss in practice.
Questions
People also ask.
What is a false signal?
It is a signal that is followed by a price move in the opposite direction to what the rule expected, and it is a normal part of using any signal.
How many signals should a trader use?
There is no fixed number, but too many signals can conflict and cause confusion, so many traders use a small set that they understand well.
Can a signal stop working?
Yes, because markets change as conditions and participants change, and signals should be reviewed regularly against fresh data.
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