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Multi-Collinearity

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cWhat's wrong with this chart?

Daily Chart of INTC:

Note: Charts in this article do not feature current values.

What's wrong with this chart is that the two indicators, RSI and CCI, are collinear. Both are momentum indicators that use a security's closing cost in their calculations. Because they're calculated using some of the same input, they're not truly independent studies. Traders can spot collinear indicators because their peaks and valleys tend to come at the same points, as do those of the RSI and CCI indicators seen on the chart. Traders who use RSI to confirm a CCI signal or vice versa are relying on methodology that any statistician would tell them was faulty.

Scan any number of disparate statistical studies and you'll locate sentences or even paragraphs devoted to the methodology used to avoid multi-collinearity or multicollinearity. (Various spellings abound, depending on the source researched.) Dictionary.com defines the term as "linear inter-correlation among variables." For example, a study on the relationship of transportation to job-interview-and-employment outcomes mentions one limitation of the study as its failure to account for the collinear relationship between car ownership and the employment outcomes being studied. Those who owned cars likely had better employment outcomes and those who found jobs likely had a higher percentage of car ownership. The two variables were not independent. Studies on outpatient medical care costs for children with special health care needs, the effect of political power in predicting genocide and mass murder, and the best methods to teach beginning readers all addressed the methodology they'd used to avoid multicollinearity.

If traders want confirmation that a signal is valid, they need the signal to come from indicators that are as independent as possible. If a momentum indicator such as RSI is used, its signal should be confirmed by an indicator that doesn't rely on closing prices for its computation. For example, a volume-based indicator such as the On-Balance Volume (OBV) or Chaikin Money Flow (CMF) index might be used.

Daily Chart of INTC with RSI and OBV:

How do traders find out which indicators rely on the same information for their calculations? Many charting platforms provide overviews and/or formulas for the indicators they allow. A search of www.investopedia.com will turn up both for many of the most popular indicators. For those who don't want to go to that much trouble, www.stockcharts.com provides a handy breakdown of the most popular indicators into three basic groups at the following link: http://stockcharts.com/education/TradingStrategies/Multicollinearity.html

Once you have the breakdown in front of you, it's as easy as choosing only one indicator from each of the three types listed: momentum, trend and volume. This should be a good starting place for beginning traders who want to avoid multi-collinearity when choosing the indicators they'll follow.
 

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