A large part of developing successful indicators is being clear, specific and objective about the concepts. For example, it is not sufficient to simply state “when the market is in an uptrend…” You must define what exactly it is that constitutes an uptrend. Examples of specific definitions might be “three consecutive higher highs,” “a nine-period moving average crossing above a 30-period moving average” or “ADX is over 20.”
Going back to our example of combining average price and average volume, we now must define every aspect of the concept and create a method of expressing this relationship objectively. First, we define the average price and volume as 40-day averages (see “Objectively speaking,” below).
Average Price = Average closing price over the past 40 days
Average Volume = Average volume over the past 40 days
Because price and volume have many different values and scales, we attempt to express one in terms of the other. In this case, we create a formula to express volume relative to price so both can be viewed simultaneously. One way to accomplish this is to look back and determine a range for both price and volume, and then build a formula that normalizes average volume to fit into the average price scale. We look back over a fairly significant amount of time (200 days) to create the range values:
Price range = (Highest average price of the past 200 days) – (Lowest average price of the past 200 days)
Volume range = (Highest average volume of the past 200 days) – (Lowest average volume of the past 200 days)
We then build a formula that normalizes volume:
Relative average volume = ((Average volume) – (Lowest average volume of past 200 days) / (Volume range * Price range)) + Lowest average price of last 200 days
Now that this relationship has been defined, we can continue the process of converting the concept into a custom indicator that can be applied to a price chart.