Chart of the Week – April 4, 2004
Brett N. Steenbarger, Ph.D.
www.brettsteenbarger.com
Is it possible to create more accurate market indicators by using formulas that eliminate lag and noise from readings? The premise of John Ehlers’ new book, Cybernetic Analysis for Stocks and Futures, is that mathematics drawn from electrical engineering—digital signal processing (DSP), to be exact—can greatly improve the performance of standard technical analysis tools.
I like Ehlers’ book and the fact that he includes TradeStation code for each of his methods so that they can be implemented by system developers and traders. A weakness of his text, however, is that he fails to conduct statistical tests that would demonstrate the superiority of trading signals derived from DSP. While the signals certainly seem promising in his visual illustrations, this is a far cry from establishing their profitability in historical and real-world trading.
One indicator that I have playing with using the Ehlers techniques is an overbought/oversold measure that I call the Volume Intensity Index. This is a very simple measure that sums the intraday advancing and declining volume for the ES futures and creates a ratio that varies between +1 (all volume is advancing) and –1 (all volume is declining). At zero, volume is evenly balanced.
To smooth the ratio, I took the summed figures and put them through a “finite impulse response” (FIR) filter. This is a weighted four period sum that eliminates short-term cycles in the data. To further ensure that high values and low values for the indicator would be equivalent, I used a Fisher transformation to ensure that the indicator values fit a normal distribution.
Below is a chart of the resulting Volume Intensity Index. It is a momentum indicator, tending to peak and trough ahead of the ES futures. Crossings of the zero line appear to have some promise in marking the transition between short-term bull and bear markets. At present, we have come well off the indicator highs despite hitting new price highs on Friday, suggesting possible weakness ahead. Note that values above +.125 and below -.125 tend to be associated with short-term market reversals. In days and weeks ahead I will be comparing the Volume Intensity Index to other momentum measures to determine whether or not the measure—and the Ehlers-inspired tweaking—have any promise.
Brett N. Steenbarger, Ph.D. is Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. He is also an active trader and writes occasional feature articles on market psychology for MSN’s Money site (www.moneycentral.com). The author of The Psychology of Trading (Wiley; January, 2003), Dr. Steenbarger has published over 50 peer-reviewed articles and book chapters on short-term approaches to behavioral change. His new, co-edited book The Art and Science of Brief Therapy (American Psychiatric Press) is due for publication during the first half of 2004. Many of Dr. Steenbarger’s articles and trading strategies are archived on his website, www.brettsteenbarger.com.