Sometimes markets move too fast and too far. This article is all about a new method to detect excess market moves. A new indicator will be presented, which overcomes many of the downsides of traditional ones like RSI or Bollinger Bands.
Overbought and Oversold Indicators
I am sure you are familiar with the traditional indicators RSI and Bollinger Bands. Legions of analysts have used them to detect excess market moves and market reversals. You might have used a RSI reading above 70 or below 30 or a market close outside of a 2 standard deviation Bollinger Band to do so. But these traditional indicators have a big downside: they are always calculated over a given period of time: 14-bar RSI, or 20-bar Bollinger Bands. You can surely adjust this setting to your market, but who tells you that e.g. a 17-bar calculation period is better than taking the last 14 or 20 bars into account? Going this way is a slippery road and you might fall down the cliffs of curve fitting.
A new algorithm for excess detection
Bollinger Bands already has the key ingredient for a useful reversal detector: it measures the market move in standard deviations. But it does the measure only over a fixed interval setting, thus missing a lot of shorter or longer excess market moves.
To overcome this restriction and find all excess moves, I did me an indicator which searches for excess moves over multiple intervals. This is how it works:
First the algorithm calculates a volatility measure. All data on the chart, prior to the testing bar, is used. The formula used is described over here. After the volatility of the market has been calculated, the algorithm measures all market moves for a given number of bars. A standard setting might be to calculate all moves between 5 and 200 bars. From this list of moves, normalised in volatility multiples, the algorithm picks the biggest moves. Then a trigger value is applied and the algorithm checks if the biggest move found is more than e.g. 3 times the expected volatility. To show the found move on the chart, the algorithm waits for another bar, and if this bar does not form a new low for bearish moves or a new high after a bull move, the move is shown on the chart. A reversal or at least an end of the exuberant market move can be expected.
On the chart above you see this new indicator in action. The right chart is Bitcoin on an hourly timeframe, the right one is German power on a daily timeframe. Both charts use the same settings and search excess moves with a length of 5 to 200 bars. The lines are fixed (confirmed) with a 2-bar counter move.
Some examples for excess detection indicator
To see the effect of different settings have a look at the chart below. All 3 charts detect moves between 10 and 200 (hourly) bars. A 1 bar confirmation delay is used. The difference between the charts is the minimum volatility multiple which is used to detect the excess. From left to right it uses a 1, 3 and 5 times the average fair bet volatility to define the minimum move.
Statistical test of excess indicator
If this indicator is any useful, the market should show a different behaviour on the bars after an excess move has been detected than on an average day. To see if this is true the signal efficiency can bet tested using the methodology described in an earlier post.
The chart above shows the excess detector applied on daily JPY Forex data. Only bullish reversals are detected. On the right side you see the average profit factor for the days after a reversal (2*vola, 1 bar confirmation) has been detected. Although it has been a falling market (magenta benchmark below 1) the signal generates showed an average profit factor of more than one – a strong indication that this indicator is able to predict a bullish move after a sell off has been detected. Even in an overall bearish market.
Usage and general thoughts
There is no indicator which will tell you what the future will bring, but a good indicator will flash a warning sign if the current state of the market is going to change. My excess indicator, like Bollinger Bands and RSI, will tell you when the markets have moved too far. It does this detection independently from a fixed period setting. You have to decide which timeframe you are interested in, e.g. short term = 3 to 10 bars, mid term=10 to 21 bars, long term=21 to 200 bars, and then use the signals of this indicator as a setup to your trading strategy.
If the indicator tells me that there has been an excess bearish move, I will not set up a new short position. I neither would set up a long position if this sell off happened in a bearish market. But I will think about using a tight trailing stop to lock in the profits of my short position.
If there has been an excess bearish move in an uptrend, I might want to start to scale into a long position, using a tight stop loss at the beginning and the let it run until my indicator flashes a warning sign in the other direction.
Never forget that money is made with position sizing and risk management, although a nice indicator can help… :)
Tradesignal Indicator Code
You can download the source code of this indicator as a txt file. Copy and paste the content of the text file into a new indicator in Tradesignal and start exploring. You will need the latest version of TS (10.2) and have a chart with at least 1000 bars of data. By downloading the indicator you are accepting the smallprint.