Swing & Position TradingTechnical Analysis

Predictive Indicators

Everyone knows the market data are fractal.  You can look at a chart of daily data, look at a chart of weekly data, and the charts basically look the same if the scales are removed.  In other words, the amplitude of the cyclic swings scale in direct proportion to the cycle period.  I call this effect Spectral Dilation because longer cycle periods have larger swings.  The Hurst Coefficient is directly related to the degree of dilation.  Fibonccians use the Golden Spiral to show the dilation factor is 1.618.  The exact degree of dilation is not important.  The fact that dilation exists is beyond question.  So, in round numbers, the spectrum amplitude increases 6 dB per octave of cycle period.  This “1/F” phenomena seems to be almost universal in physical systems.

Here was my epiphany regarding market data:  Like everyone, I knew the market data was fractal.  However I completely disregarded this fact when looking at oscillator type indicators such as the Momentum, Stochastic, RSI, MACD, or CCI.  In a nutshell, all these indicators are first order differentiators.  That is, they all take just one difference in their calculation.  A basic principle of filtering is that simple differencing has an attenuation rolloff of 6 dB per octave per order of the filter in the attenuation band of the filter.  Therefore, all of these indicators roll off at the rate of 6 dB per octave like a simple HighPass filter.  Since the data amplitude swings are increasing at the rate of 6 dB per octave, the best these indicators can do is to flatten the response of the data spectrum in the indicator output.

Figure 1 shows the practical effect of a simple HighPass filter when applied to some sample market data.  Note that during the period of the long uptrend the oscillator does not have a zero mean.  That is, the wiggles are not centered on zero.  The interpretation is that the data has not been fully detrended and that the longer cycle period signals are “leaking through” the rejection band of the filter.

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Figure 1. A Simple HighPass Filter Does Not Accommodate Spectral Dilation

The attenuation rate is increased 12 dB per octave in the attenuation band by using a second order HighPass Filter.  The filter attenuation exceeds the 6 dB per octave Spectral Dilation in the data and therefore effective filtering of the longer cycle components is accomplished.  Figure 2 shows the contrast between using a first order HighPass filter and second order HighPass filter.  The dotted red line is the original response given in Figure 1 and the solid blue line is the second order response.  Note the second order response provides a nominal zero mean for the oscillator and that much of the lag induced by the “leaking” longer cyclic components is eliminated.

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Figure 2.  The Second Order HighPass Filter Establishes a Zero Mean and Reduces Lag of the Oscillator

I call the combination of my SuperSmoother filter and the second order HighPass filter a “Roofing Filter”[1] because it provides a roof over the data spectrum so the data is preprocessed for use with any indicator that may follow.  The Roofing filter is not a bad indicator in its own right.  In a sense, the Roofing filter is a kind of BandPass filter.  The Roofing filter differs from a BandPass filter because the rejection response on the high frequency side is specifically designed to reject aliasing noise and the second order rejection response on the low frequency side is specifically designed to eliminate the effects of Spectral Dilation. 

The MESA Stochastic is just a standard Stochastic calculation preceded by a Roofing filter, and is just one example of the use of the Roofing filter.  The two indicators are compared in Figure 3.  I rememberGeorge Lane, a bombastic speaker, list the myriad of rules in the use of the Stochastic.  Some depended on %D crossing %K on the right side or left side.  Also one rule was “In an uptrend, don’t go short until %D crossed below 80 three times”.  As we now see, all those rules are just plain silly.  The distortion of the Stochastic in an uptrend is due solely to Spectral Dilation.  When the Roofing filter precedes the Stochastic, the result is an easy-to-use oscillator whose swings are nearly in synchronization with the swings in the prices.

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Figure 3.  Roofing Filter Removes Spectral Dilation Effects from Indicators

Figure 4 shows how the MESA Stochastic would be used with conventional wisdom.  Conventional wisdom says to wait for confirmation of the turning point before making a trade entry.  That  translates to rules that say “Buy when MESA Stochastic crosses over 20” and “Sell Short whenMESAStochastic crosses under 80”.  The green and red arrows indicate application of those rules.

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Figure 4.  Conventional Wisdom Says to Wait for Confirmation Before Making a Trade Entry

A casual review of those rules seem to confirm they are good rules.  Not trusting anecdotal evidence, I wrote a trading strategy  that contain ONLY those rules.  There were no other qualifying rules and no stop exits.  When I ran that trading system on 10 years of continuous ES daily data I got the Equity Growth Curve shown in Figure 5.  The trading system using conventional wisdom was a consistent loser!

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Figure 5.  Trading System Using Conventional Wisdom is a Consistent Loser 

A quick analysis shows us what went wrong.  First, let’s assume there is a 20 bar dominant cycle in the data.  This happens to be more or less true from my spectral measurements.  It is also logical from a fundamental perspective because the companies that comprise the S&P Index generally have to make their numbers on a monthly basis.  So, we are generally expecting a 10 bar move to the upside and a 10 bar move to the downside.  Now, let’s add up the lag in our calculations.  The Roofing filter and the Stochastic both have about two bars of lag.  We can only make a trade entry on the bar after the signal, so there is another bar of lag.  Finally, we average about three bars of lag waiting for confirmation.  When we add these lags, we find they total 8 bars.  We generally have 8 bars of lag in an expected 10 bar move.  No wonder the trading strategy is a consistent loser!

There is a temptation to simple reverse the rules to convert the trading strategy to a winner.  That’s like doing brain surgery with an axe.  I avoid such tactics because sloppy rules like that generally return to bite you.   There is a much more elegant solution available.

Anticipating the price turning points is done by creating rules to Buy when the MESA Stochastic crosses under 20 and to Sell Short when the MESA Stochastic crosses over 80.  The rules are displayed as the green and red arrows overlaid on the MESA Stochastic indicator in Figure 6.

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Figure 6.  The PredictiveMESAStochastic Anticipates the Cyclic Turning Points 

As before, I created a trading strategy using ONLY these rules and ran the strategy over 10 years of continuous ES daily data.  The resulting equity growth curve is shown in Figure 7.  Now we have a consistent winner!  It is not too much of a job to add some ancillary rules, stops, and so forth to have a real trading system.

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Figure 7.  Equity Growth Curve Using the PredictiveMESAStochastic Rules 

Nothing has changed in the indicator calculations.  We still have 2 bars of lag due to the Roofing filter and the Stochastic calculation.  We still have one bar of lag making the trade entry after getting the signal.  The difference is that we have a minus 3 bars of lag because we are anticipating the turning point of the MESA Stochastic indicator.  Therefore, we have a net 2 bar lag of our trade entry relative to the nominal extremes in the price movement.  In other words, we have virtually predicted the point at which the price will reverse its swing.

The concept of anticipating the cyclic turning point is used at www.StockSpotter.com.  Figure 8 shows the Swing Trade Setup Analyzer.  Two indicators form the basis of the anticipating the price turning points, the Cycle indicator and the Momentum indicator.  Note that both indicators have a zero mean and are also very smooth, showing that the effects of Spectral Dilation and Aliasing Noise have been removed.  The Cycle Indicator peaks and troughs precede the peaks and troughs in the prices, with  troughs indicated by green bars and peaks indicated by red bars. The blue line Momentum Indicator behaves analogously to the Stochastic.  That is, it has some lag.  A swing trade setup occurs when the Cycle indicator reaches a trough within the last few days and the Momentum Indicator is declining or at a minimum.  The swing setups are shown by the yellow and green triangles on the price chart.

Figure 8 is not a cherry-picked example.  You can analyze any stock for FREE at StockSpotter.com using the Swing Trade Setup Analyzer for yourself.  In fact, there are several more  valuable  indicators  there  for  FREE.  StockSpotter.com also features scanners that identify a variety of trading situations.  Premium members receive explicit buy and sell signals at the end of the trading day for exercise at the market on the open of the next trading day.  All signals are given IN ADVANCE and then the hypothetical trading performance is transparently tracked and reported.   

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Figure 8.   StockSpotter.com Anticipates Turning Points 

CONCLUSIONS
There are several important concepts that have been introduced.  These are the “take-aways” that you should remember for your trading.

1.  Market data has Spectral Dilation.  Spectral Dilation distorts the interpretation of common technical indicators.

2.  Spectral Dilation must be removed using my Roofing Filter or some other filtering technique for effective swing trading.

3.  Waiting for confirmation from an indicator generally does not produce a profitable swing trading strategy.

4.  Anticipating price turning points is the basis of a good swing trading strategy.  From a statistical point of view, anticipating a price turning point is similar to expecting a reversion to the mean.  This technique is utilized in StockSpotter.com.

John Ehlers can be contacted on this link: John Ehlers

John is the President of MESA Software, co-founder of StockSpotter.com, principle of MESA Vector Asset Management LLC, and Contributing Editor for Stocks & Commodities magazine.

He is an Electrical Engineer, receiving his BSEE and MSEE from theUniversityofMissouriand did his doctoral work at The George Washington University, specializing in Fields & Waves and Information Theory. He is a Member Emeritus of Sigma Xi, the Scientific Research Society.  He has been a private trader since 1976.

John is a pioneer in introducing theMESAcycles-measuring algorithm and the use of digital signal processing in technical analysis.  He developed Maximum Entropy Spectrum Analysis (MESA) over three decades ago.  

John has written extensively about quantitative algorithmic trading using advanced DSP (Digital Signal Processing) and has spoken internationally on the subject. His books include “MESA and Trading Market Cycles”, “Rocket Science for Traders”, “Cybernetic Analysis for Stocks and Futures”, and “Cycle Analytics for Traders”.  His approach is unique. Any technique must first work on theoretical waveforms before testing against real-world data is attempted. 

John is the President of MESA Software, co-founder of StockSpotter.com, principle of MESA Vector Asset Management LLC, and Contributing Editor for Sto...

timsk

Legendary member
7,014 1,845
"A basic principle of filtering is that simple differencing has an attenuation rolloff of 6 dB per octave per order of the filter in the attenuation band of the filter."

I'm sure Mr. Ehlers knows what he's talking about - but does anyone else? I gave up reading the article when I got to the second paragragh and read the sentence quoted. Double dutch to me!
Tim.
 
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Trader333

Moderator
8,495 881
Well it is an advanced article and technical in nature but it all made sense to me so I am guessing that your education must be "sadly lacking" :)
 

timsk

Legendary member
7,014 1,845
Well it is an advanced article and technical in nature but it all made sense to me so I am guessing that your education must be "sadly lacking" :)
:LOL:
Hi Paul,
Yes, I'm sure you're right about my education! If you understand what he's on about - then that's good enough for me.
Tim.
 

Splitlink

Legendary member
10,850 1,232
I'd like to say that I understood this article, but I did not.
 

Splitlink

Legendary member
10,850 1,232
I wrote the above post without reading the previous ones. Now that I have, thank God that I'm in good company!

I always thought that Paul was a cut above the rest of us mere mortals!
 

valleyvintner

Junior member
18 0
Your comment poses a paradox. I strongly agree on some points and disagree just as strongly on others.

John Ehlers' very considerable reputation didn't come out of thin air. He has earned it by providing methodologies and software products that really work. His prominence in technical analysis is results-driven, by contrast with the marketing-driven profiles of many present day gurus.

On the other hand your view that one might make money by watching a market's supply-and-demand seems unpromising at best. Certainly we want to know "which way?" but what we really need to know is "when?" I'm curious about your "other data and instruments available to any trader with half a wit." If you refer to such traditional indicators as Relative Strength, Directional Movement, Williams %R and others that use arbitrary lookback periods I would advise looking elsewhere for something statistically valid that both avoids bad trades and indentifies promising ones. John Ehlers has developed and published several such statistics based tools that can be viewed on his website and in his articles, notably his application of the Hilbert Transform in identifying the current dominant cycle in any market and on any time frame. If you're unfamiliar with this aspect of his work one can understand your bafflement, but I'd urge you to explore his approach with a more open mind.

I think you err in saying, "...nothing as hard-wired as technical analysis will ever be able to automatically adapt, or therefore be useful, over any appreciable period of time." I completely agree with you if you refer to the traditional indicators that I mentioned earlier but I very much disagree with the notion that technical methods founded on the kind of applied science found in electronic signal analysis, for instance, have no value to the futures trader. First, technical analysis nowadays is anything but "hard wired" or inflexible. Second, few phenomena resemble market price movement more than signal behaviour.

Another ex-engineer who has created useful statistics based software is Cynthia Kase, author of "Trading With The Odds." The title speaks for itself. I believe it's long out of print but an ebook version exists and can be Googled. Her proprietary software suite, "StatWare," rewards attention also.

Again, I agree with you that no single technical indicator has all the answers. What is required is a realistic application of complementary tools driven by a top-down strategy that goes well beyond technical analysis. In my experience, for example, volatility is a core value while volume and open interest are all but useless.

With every good wish,
valleyvintner
 

valleyvintner

Junior member
18 0
John Ehlers

Do you have any empirical proof of that claim?
The comment is not a claim; it's an observation. Just look around. In particular, check out his history with TASC and Futures magazines. Many "gurus" would demand serious money for the sort of knowledge that Ehlers freely gives away.

If his work were not of value to stocks and futures traders, we wouldn't follow him in our thousands. But I do also caution against relying solely on a tool like the MESA Stochastic. Other methods - notably the Bollinger Bands ANOVA procedure - in combination with the engineering-based methods of Ehlers and Cynthia Kase - can produce a focused 3-D view of a developing swing.
 

Sigma-D

Established member
648 61
The comment is not a claim; it's an observation. Just look around. In particular, check out his history with TASC and Futures magazines. Many "gurus" would demand serious money for the sort of knowledge that Ehlers freely gives away.
Look around? What the hell does that mean? I asked you for empirical proof that his methodologies and software products work.

He's just another pie-in-the-sky engineer that has so fallen in love with his discipline of choice, he imagines it gives him 'signs' in a totally unrelated discipline.

Seriously, if any of these 'gurus' had anything of specific worth to trading with their cycles and waves and harmonics and geometric shapes and other assorted voodoo, they'd have an undeniable and unmistakable hit with just about every trader looking to ply their trade. They don't. Each of them has far greater number of detractors showing where their methods don't work than those espousing the efficacy of the same.

I'll give you the test that all phantom prognosticators should be set for proving the magic potion of choice - show us how YOU will use Ehlers to trade any instrument of your choice going forward this week in real-time.

My guess is you'll find a way to tap dance around that one and disappear.

If his work were not of value to stocks and futures traders, we wouldn't follow him in our thousands. But I do also caution against relying solely on a tool like the MESA Stochastic. Other methods - notably the Bollinger Bands ANOVA procedure - in combination with the engineering-based methods of Ehlers and Cynthia Kase - can produce a focused 3-D view of a developing swing.
Follow him in your thousands? You know thousands of stocks & futures traders do you and they all use Ehlers. I substantially doubt that. As for Kase her company markets software which has a fairly poor reputation generally in the industry - probably because it's also based on a one-time, one-approach methodology that worked, for a while, back then, but has since been invalidated by the significant changes which the financial markets have experienced.

It is safe to say two things:-

1. Any methodology, system or process invented and proposed more than 5 years ago for trading the financial markets has a very high probability of being totally worthless today.

2. Any 'guru' marketing software, services, products and books on the strength of their past glories do not warrant our attention.
 

davies

Newbie
8 2
Sigma -D

I think you have "hit it on the head" with your comments.

You are a very entertaining writer and after reading many of your comments - you are open to admit that you cannot find a way to make trading work for you .

Just out of interest - how long have you been trying ? - not just in approx years - but in actual total hours spent reading / learning / studying charts and actually taking trades in what ever instruments you have tried?

I wish you well and please keep me entertained as well

Thank you
 

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