periodicities come through nearly unscathed.For this indicator you need to identify the short-term cycle for the market you are analyzing. Detrendingthe data as mentioned earlier will assist you in identifying market lows and finding the dominantshort-term cycle. Once the cycle has been identified, select an exponential average equal to one half ofthe short-term cycle. For the Dow Jones Industrial Average, the short-term cycle is 14 to 15 days.Therefore, you should use seven days for your exponential average. Most software programs allow you towork with periods instead of smoothing constants when dealing with F exponential averages. Periods aresomewhat easier to grasp than smoothing constants. The reason behind using an average equal to one halfof the short-term cycle is to maximize the price movement without smoothing the dominant cycle.Only through years of use and experimentation have I been able to determine the second part of theequation: That is, the length (or period) of the second exponential average used with this trend-followingindicator. Simply stated, use a period six times the value of what you used for the short-term average. Ifyou used seven days for the short one, then use 42 days for this one. I suppose, for credibility, I shouldhave told you that by using six times the short average you were applying the principle of "half-dozening"which, of course, everyone knows about. But, in case you don't, half-dozening refers to the completelyarbitrary rule c of using a longer term average equal to six times the short average. This was found aftermany years of experimentation.The relationship between these two is similar to the Moving Average Convergence Divergence (MACD)first written about by Gerald Appel. Merely subtract the longer period average from the short periodaverage and you are left with an oscillator that will give quicker and more timely signals than yourstandard two-moving-average crossover system. Buy and sell signals are generated by using an arithmeticmoving average on this oscillator. Again, by much testing, I have found that the period for this averageshould be three times the value of the short-term exponential average. In this example, that would be 21days.
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Stocks & Commodities V. 5:2 (64-66): Trend of the trend by Gregory L. Morris
That's it: a simple trend-following indicator that works. Figure 1 shows the Dow Industrials and thisindicator over the last 14 months with the buy and sell signals identified. Note how the cursor will helpyou identify actual crossovers by showing the value of the indicator and the value of the movingaverages. Figure 2 shows the same information but only for the last seven months.
Blindly following canned indicators can lead you into a falsesense of securityAn additional technique to help avoid or reduce whipsaws is to construct a trading band around anarithmetic moving average that uses the same period as the buy/sell average discussed above (21 days).This trading band is on the price action itself and the percentage for the band is one that will encompassmost of the data or at least 90 to 95% of the data. The best buy and sell signals occur when the priceaction is at or near the limits of the trading band. Obviously, buy signals should be accompanied by priceaction at or near the lower band and sell signals at or near the upper band. If it is near the center or nearthe opposite side, you ignore the signal given by the oscillator. If the price action is outside of the tradingband, the signal is probably premature. That's the nature of momentum and is another subject entirely.Figure 3 shows the Dow Industrials with trading bands of 4.5 percent on the top plot and the indicatorwith the new buy and sell indications at the bottom. Note that the indicator plot was changed to just a lineplot instead of the histogram plot as shown in Figure 1. Again, the last seven months are shown for betterdetail (see Figure 4). Notice the reduction of signals when applying the trading bands to the system.Remember, determine the dominant cycle. Select the short exponential average equal to one half of thatcycle. Use a longer term exponential average equal to six times the short one. Then place an arithmeticmoving average over the difference between the two exponential averages. The length of the arithmeticaverage should be three times that of the short exponential average. Use trading bands to help filter outsome of the whipsaws. Whipsaws are a fact of life in a trend-following indicator--accept them and youwill always be on the right side of the market. If you start with a series of small losses, you will really getexcited when the big moves come.I have prepared a small list of parameters that I have discovered to be the best (so far) when utilizing thistechnique. The first number is the short exponential average, the second number is the long exponentialaverage, and the last number is the arithmetic moving average used on the oscillator and for the tradingbands.
Selected ParametersJust to show you that this can work elsewhere, Figure 5 shows a sell signal just before an 11.88 pointdrop in the S&P 500 in September 1986.
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Stocks & Commodities V. 5:2 (64-66): Trend of the trend by Gregory L. Morris
These are just a few examples of the parameters what I have found to be fairly reliable. As a stand-aloneindicator, this one works quite well. However, if used with a basket of indicators, overall results improvesignificantly.Gregory L. Morris is the president of G. Morris Corporation, which is engaged in technical analysisconsulting and software development.
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Stocks & Commodities V. 5:2 (64-66): Trend of the trend by Gregory L. Morris
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Stocks & Commodities V. 5:2 (64-66): Trend of the trend by Gregory L. Morris
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