Volatility, the mass index and the reversal bulge
Uncertainty breeds change; that is the underlying tenet of the Mass Index, which posits that an increase in volatility precedes a shift in price trend. Developed by Donald Dorsey, the Mass Index monitors range expansion using the high-low range as a proxy for volatility. The indicator itself does not determine the current, or potential, direction bias. Instead, it suggests when the trend will reverse.
Simple price observation or other indicators, such as moving averages, are necessary to determine the current trend.
Volatility is defined in a number of ways. There are measures based on simple arithmetic, there are definitions rooted in sophisticated statistical analysis and there are also definitions that are based on the pricing behavior of related options.
In the simplest terms, however, most traders think of volatility as the extent and frequency of price changes. Periods of high volatility are marked by price changes that are large and numerous. Periods of low volatility have few price changes, and the price shifts that do take place keep the underlying market in a relatively narrow range.
When market players agree on the price equilibrium, prices are stable. Buyers aren’t willing to offer much more than the current price, and sellers aren’t willing to accept much less than the current price. Trades may happen, but they will happen at the status quo. When market players disagree on the price equilibrium, however, prices aren’t stable. The extremely bullish may bid up prices with abandon, while anxious sellers may follow with a fire sale.
Many traders, not just Dorsey, feel that the ingredients of these high-volatility periods logically lead to trend shifts. In other words, these are times of change, and times of change experience larger price swings — and more price swings — than times of certainty.
The Mass Index has a simple calculation. It is composed of:
- A nine-period exponential moving average (EMA) of the high-low differential
- A nine-period EMA of the nine-period EMA of the high-low differential
- The EMA ratio is the EMA of the differential divided by the EMA of the EMA. The Mass Index is the 25-period sum of this EMA ratio. The complete formula is as follows:
According to Dorsey, a so-called “reversal bulge” is a probable signal of trend reversal (regardless of the trend’s direction). Such a bulge takes place when a 25-day mass index reaches 27.0 and then falls to below 26.0 (or 26.5). A nine-day prime moving average is usually used to determine whether the bulge is a buy or sell signal.
See “Divining the dow” (below) for a chart of the Dow Jones Industrial Average along with the Mass Index. When the Mass Index rises above the setup line then drops below the trigger line, it indicates a possibility of a price reversal. This is the reversal bulge. It is impossible to establish the direction of the trend using the Mass Index alone, but it tends to foreshadow trend changes.