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ARMS INDEX


Nasdaq and Thrust Oscillator (Part II)

03/02/01 09:24:31 AM
by Dennis D. Peterson

The thrust oscillator (TO) uses market breadth measures to determine market trend.

Security:   $compq
Position:   N/A

Using moving averages as an indicator has an inherent fault: they lag. When price changes, the moving average will change in the same direction -- but only after a delay. Systems employing moving averages are trend-following systems. They are trend-following systems that lag. If the stock or index you are following is in a trend, then trend-following systems should keep you on the right side of the trend. The lag causes you to miss early opportunities but gives you better assurance of being on the right side of the trend -- that is, going long in an uptrend and short in a downtrend.

Indicators that measure values at different points in time measure momentum. Price momentum measures price differences at two different points in time. When indicators measure momentum they are called oscillators. Momentum often leads. That is, if you measure the momentum of price you will often see a change in momentum before you see a change in price. Momentum indicators, or oscillators, are good at establishing overbought and oversold thresholds and even better at recognizing when there is a divergence between, for example, price change and momentum of price change.

Trend-following indicators should be used when a stock or index is trending and an oscillator when a stock or index is in a trading channel. It is more reliable to follow a trend than to predict the direction of change. In other words, trend-following indicators, if properly used, should produce more reliable results than those that try to predict.

Is the silver bullet of trading a trending or momentum indicator? Many successful traders use only patterns, coupled with gap up or gap down events, dead cat bounces, and other pattern related events, so they would dismiss the whole discussion at the outset. However, many successful traders use trend-following systems. Obviously there is more than one way to be successful. For indicators the best choice might be to use a reliable indicator on data that is inherently leading.

The MACD, moving average convergence/divergence, is a momentum indicator created from moving averages. In the last posting I used two moving averages with marginal success. I chose market breadth measures because breadth on its own can be a leading indicator. I optimized the moving average periods to squeeze what I could out of the information provided by TO (thrust oscillator). Still, it wasn't very profitable. But misusing an indicator is hardly a reason to abandon it, especially when the potential is strong. MACD is the same as the price oscillator (PO) used with an exponential moving average of PO. PO is the difference of two moving averages. Because it compares the average values of one period with the average values of a different period it is an oscillator. Having different periods is equivalent to having two different points in time. To create MACD, use PO and the moving average of PO. The moving average of PO is called the signal line and is denoted with a dashed line. For MACD, the traditional choice, whether you are looking at daily or weekly data, is a PO creating the difference between exponential moving averages of 12 and 26 periods. The moving average of PO, or signal line for MACD, is traditionally nine periods.



Figure 1: Nasdaq Composite (bottom chart) and equity performance of $1,000 invested in 1996 (top chart).
Graphic provided by: MetaStock.
Graphic provided by: Data vendor: eSignal<.
 
Figure 1 shows the results of a trading system using MACD on TO for the Nasdaq Composite. I did optimize, however, on the components of MACD. I wrote out MACD as PO and the moving average of PO. The result for the recent five-year period was a PO of 14 and 28 days using daily Nasdaq Composite closing prices, and a moving average of PO of three days. I also retained the volatility check that I mentioned in Part 1. The volatility check compared the standard deviation of volatility for the most recent 14 days with the standard deviation of volatility 30 days ago, again using 14 days to calculate the standard deviation 30 days ago.

For long entry the rules were

PO greater than the signal of PO, (same as a MACD approach)

and

current price volatility standard deviation less than 1.1 times price volatility standard deviation 30 days ago.

For long exit the rules were

PO less than the signal of PO, (same as a MACD approach)

and

current price volatility standard deviation less than 1.1 times price volatility standard deviation 30 days ago.

Ideally you want the equity curve (Figure 1: top chart) to move up with few dramatic downturns. Since I only wrote rules for a long position, the equity curve shows periods when the system exited and the equity was just sitting. These sitting periods show up as flat or horizontal equity growth, that is no growth or loss. You also would want to see the equity curve keep moving up even if the Nasdaq Composite was moving down. I established entry to be made with a one day delay. Exit was allowed on the same day.

The performance of the system was with $1,000 invested in 1996

- annual percentage gain/loss = 41.24%,
- total winning trades = 61,
- total losing trades = 47,
- largest win = $406.43,
- largest loss = $118.63,
- most consecutive wins = 6,
- most consecutive losses = 3.

I like having the largest loss getting down to $100. MACD on its own has problems when it is used below zero. The volatility check helps stay on the right side of the momentum. Otherwise this system is not using price directly at all. Still, the Russian debt default of 1998 is a problem. Few trading systems are bulletproof.




Dennis D. Peterson

Market index trading on a daily basis.

Title: Staff Writer
Company: Technical Analysis, Inc.
Address: 4757 California Ave SW
Seattle, WA 98116-4499
Phone # for sales: 206 938 0570
Fax: 206 938 1307
Website: www.traders.com
E-mail address: dpeterson@traders.com

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