Thursday, February 28, 2013

IDENTIFYING CYCLE TOPS AND BOTTOMS USING ENVELOPES

Chart 1 -  This chart shows the ebb and flow of prices, but identification of the Trading
Cycle bottoms and tops requires a little effort to be visible to the untrained eye.


Chart 1 - Do you see the cycles in this chart?

 Chart 2 -Cycles are measured from bottom to bottom. Every time frame of every market has a dominant Trading Cycle averaging from 14 to 25 bars as measured in weeks, days, half days, hours, minutes or ticks. Most Trading Cycles in the stock and  futures markets tend to cluster in the 18 to 22 bar range, averaging 20 bars from bottom to bottom. In Chart 2, SPX exhibits a daily trading cycle of 23 days from bottom to bottom. The trading cycle tops and bottoms are indicated by the arrows.


 Chart 2 - the arrows indicate trading cycle bottoms and tops.

ENVELOPING PRICES


Prices cluter above and below a moving average. If we can identify a potential cycle (bottom to bottom) then we can draw a moving average the length of that cycle. To center that average over the data it averages we need to shift the average half the length of the cycle. Fortunately, many have studied cycles and we know what the likely cycle lengths are. One very common cycle is the lunar cycle which runs about 21-23 trading days (explains the 20 day MA).

We can draw a time shifted MA and draw a line above and below this MA by a given percent. During normal market volatility about 2.3% above/below the MA seems to be a reasonable choice. Below is a chart using a 21 day MA time shifted and an envelope 2.3% above and below that MA.



Chart 3 - Envelope highlight cycle tops/bottoms

ENVELOPES WITHIN ENVELOPES
If we enclose the first envelope within a second envelop of a longer cycle and select an appropriate envelope width then the envelopes should touch or cross at critical points and these points become points to enter (bottom lines cross/touch) or sell (top lines cross/touch). Another common cycle is the 34 TD (Trading Days) cycle.  
 Chart 4 - Envelope in an envelope and channel line signals

As you have already figured out - because the envelopes are offset they lag real time prices and you will have to project the envelope lines. This means some judgment is called for, still it is an improvement over the chart without envelopes.

To be continued......

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