From the July 01, 2010 issue of Futures Magazine • Subscribe!

Technical indicators: A statistical approach

Figure “Pennies & points” (below) shows a side-by-side comparison of five-minute ES and INTC charts on March 26, 2010, with standard MACD and a new “statistical” MACD (MACD SD) plots below the bar charts. Both MACDs input the typical (12, 26, 9) moving average length values. MACD SD takes one additional parameter, the price history length, which will be used to calculate a recent MACD mean and standard deviation. In this example, price history length was set to 400 bars. The standard MACD has used an overbought/oversold level of 1.5 points for the ES contract and $0.05 for INTC. The “statistical” MACD SD uses a fixed two-sigma overbought/oversold level (two standard deviations) for both ES and INTC. The MACD SD can be moved across assets without modification.

(Click to enlarge chart)

Extension & compression

Converting technical indicators to statistical z-score outputs can be helpful whenever absolute prices are referenced. Another example of this comes from a price extension/compression indicator. In this case, the trader is interested in gauging the extent of recent price action in a rotational market: Has a recent move been significant enough to consider fading the market expecting some reversal or retracement in price?

One method of measuring price extension/compression calculates the “highest high - lowest low” difference over the last n bars. If the difference is greater than some average price range, the assumption is that a significant price move has occurred. But when price movement is asset-specific, the measurement is complicated when moved from one chart to the next. Just as in the case of the MACD, a statistical approach is preferred.

A new indicator average price range (APR) has been written using the z-score techniques of standard deviation to measure price extension and compression. “MACD gets some help” (below) shows the MACD SD overlaid with the statistical APR on the Russell 2000 E-mini futures (TF) contract, 233-tick, on Dec. 30, 2009. APR SD produces a cyan-colored signal when recent price extension is above the two standard deviation level. Price compression is indicated when the APR SD indicator is below the negative two standard deviation level.

(Click to enlarge chart)

Using the MACD SD and APR SD in tandem offers the trader possible entry signals. While it must be said that this chart gives a particularly compelling illustration of the indicators, the theory, from a technical perspective, is consistent: Price extension may indicate a point of market rotation and MACD cross-over provides a reasonable entry point. Once again, there are no changes to the z-score based technical indicators when moving them to different assets.

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