This week has been an ideas week. An unusual number of clients are asking for my opinion on the ideas that they want to program into an expert advisor. Divergence and volatility keep popping up as themes for the week.
Simple Volatility Filter
Volatility is one of those factors that you cannot ignore in trading. It highlights the overall risk context of the market and says something about the likelihood for a trade to get some wheels.
The number of tools that we have to study volatility is unfortunately very limited. Almost everyone uses ATR, which is the average true range. The calculation for it is very basic. The true range is simply the high minus the low. The ATR is simply the average of all the true ranges over a certain period. Most traders use a 14 period ATR by convention.
I sent the chart below to a client in Australia yesterday who asked if I had any ideas for a volatility filter. It compares a fast and slow volatility window using ATR. The red line represents the 14 period ATR, which I call the fast line. The blue line represents the 300 period ATR, which I call the slow line. I suggested that period he could use the fast line appearing above the slow line as an indicator of high volatility. The opposite indication would indicate low volatility.
I created the above chart by dragging and dropping the ATR custom indicator onto a chart. I then dragged and second ATR indicator onto the first ATR indicator. Doing that way overlaps the lines. 0therwise, you would see two lines in separate windows.
When I opened MetaTrader again this morning, the same chart was left open. I immediately noticed that the line crossings appeared to match up with some of the longer term trends. Although it would not indicate the direction of a trend, the ATR crossings might prove useful as a trend detection indicator. If you decide to research this idea, please leave your comments and observation on the blog page below. I enjoy hearing from my readers.
I buy into the idea that the market contains price points that are more relevant than others. A lot of the math that I work with involves autocorrelation, which many refer to as the long term memory function. It’s a mathematical tool that allows nerds like myself to find hidden statistical patterns among a bunch of noise in a signal.
Divergence takes a similar idea and applies it to indicators, the most common of which are the MACD, RSI and stochastics. When the price rises above a previous critical point and the indicator does not exceed its previous critical point, then divergence exists. Most traders claim that divergence signals the potential end of a trend.
My biggest gripe with divergence is that the length of trends exhibit random periods. I’ve done plenty of independent research on this topic. Regardless of the method that you use to pick market tops and bottoms or how you define a trend, the time period of the measured trend is always random. It has a probability density, but it definitely does not have a set number.
Divergence completely fails to address this concern. There’s no reason why you can’t have 2 divergences or even 5 divergences in a trend. Divergence does not help the trader distinguish between the end of a trend or a continuing trend. You could use divergence as a trend detection tool, but by that point some traders are already calling for it to end. My personal opinion is that it’s not very useful.
My other complaint with divergence is that the method for picking critical points is totally arbitrary. If you put 10 traders in a room and ask them to draw a trend line, you will get 10 different answers. The absence of consensus on such a basic concept ought to say a great deal about the value of subjective interpretation.
Traders also attempt to draw the points between swing highs and lows. That task should be obvious, but it’s not. I always recommend using the zig zag indicator when customers want to go down the swing trading route. They quickly discover the same problem – how sensitive should the settings be. Again, we circle back to the issue of period length. The swing high that Bob’s Zig Zag settings draw looks like market noise to the swing highs that Alex draws.
My opinion is to stay away from divergence and look for other techniques.