Thursday, February 28, 2013

Taking the mystery out of cycles

DETRENDING TAKES THE MYSTERY OUT OF CYCLES

Historical cycles show great potential for low risk trades. But to make cycles tradable it is
necessary to define the tops and bottoms so they can be identified and traded with
mechanical buy and sell signals.

For over 50 years the non-profit Foundation for the Study of Cycles has been
using a simple procedure called centered detrending to identify cycle lengths in all
natural phenomena, including economic activity. The advantage of centered detrending
over Fourier analysis and Spectral analysis is that you can visibly observe the historical
cycle bottoms and tops. This takes the "mystery" out of cycle trading and analysis. When
you can look back over 20 years of price history and actually see the consistency and
tradability of cycles, it is easy to have the confidence to trade them. After all, if you
cannot see cycles in price activity how can you put your money on the line to buy a
bottom or sell a top. We are not looking to trade the big bottoms and tops that occur as
the trend reverses, but the bottoms and tops of the shorter-term cycles occurring in the
direction of TREND.

The process to detrend a cycle is simple:


1. Calculate a moving average the same length as the potential Trading Cycle. For
most markets use a 20-bar moving average of the close. But instead of plotting
the moving average on the day of the last calculation, it is centered (or plotted) in
the middle of the cycle. For example, the 20-day moving average is plotted back
10 days from the most recent close. This is called a centered moving average as
it is plotted in the center of the cycle.




Chart 5 – Centered Detrend -Trading Cycle tops and bottoms are easy to see in the centered detrend. 

2. Subtract the moving average from the high and low of each price bar and plot the
results around a zero line directly below each price bar. The zero line represents
the centered 20-bar moving average.
3. The centered detrend at the bottom of Chart 3 mitigates the effects of trend and
allows the highs and lows of the trading cycle to be easily seen. This process can be easily programmed into many of the popular trading platforms. Alternatively you can use the DPO indicator in StockCharts.com.

Chart 6 - The chart below has been compressed to show more cycles. The highs and
lows of the centered detrend correspond to the highs and lows of the trading cycle. We know from our envelope analysis that 2.5% above or below the MA for 20 TDs contains most of the price movement for the SPX. With the SPX at around 1500 that is 37 points above the zero line is extreme and indicates an imminent sale or 37 points below the zero line is an oversold condition and indicates an imminent buy. But, these are rare occasions and we need tighter ranges (probably1.25% or 18 points above/below the zero line).


 
If you are thinking that this is the indicator for which you have been searching…
there is still one problem. Because the centered detrend lags prices by one-half the length ofthe cycle, or 10 bars for a 20 period cycle, the centered detrend is excellent for showing historical cycles, but cannot be used for real-time trading (same as with envelopes), but it reveals information regarding cycle amplitudes.



 
Chart 6 Compressed Chart with Centered Detrend – Cycle tops and bottoms occur at the highs and lows of the detrend which shows limits to how far prices can move above and below the centered moving average (which is the zero line in the bottom centered detrend).

 

However, we now have something to look for -- A real-time oscillator that matches the
centered detrend and the cycles.

OSCILLATORS SHOW CYCLE TOPS AND BOTTOMS

Chart 7 -
The standard oscillators in Stockcharts.com can be overlaid on the centered detrend (or on top of prices) in the search for an oscillator that tops and bottoms as the trading cycles top and bottom. Not surprisingly, the performance of these oscillators for identifying trading cycle tops and bottoms can be improved by a few simple techniques.

To use an oscillator to identify cycle tops and bottoms look for three characteristics:

1. The oscillator turns when prices turn
2. The oscillator does not "wiggle" much at cycle tops and bottoms
3. The oscillator has amplitude moves that take it to the extremes of an allowable range as the cycles bottom and top.

One such oscillator is the Wilder RSI. If the RSI 3 is used it provides frequent enough oscillation to fit a swing trader's needs. A smoothed RSI with a 3 bar averge is best (RSI3M3). It shows the bottoms and tops of the trading cycle almost as well as the centered detrend and can be used as a mechanical trading signal and cycle identifier… And the RSI3M3 is current to the most recent price bar, turning down in this chart to identify the most recent trading cycle top (not normally identified by the centered detrend (DPO)).

OSCILLATOR/PRICE PATTERNS GENERATED

Chart 7 –
The RSI3M3 oscillator is current to the most recent price bar and shows cycle tops and
bottoms as well as the centered detrend.

NOTE: Many use the RSI without understanding its relationship to cycles. By using 20/80 lines we may miss some trades that could be taken if we used 30/70 lines. Still we caught good entries at 1, 3, 5, and 7. We got good exits at 2, 4, 6 and 8. Using 20/80 or 30/70 is an individual decision (20/80 is a more conserative approach).


To be continued.....

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