Sunday, 23 October 2011

Trend Following and Price Choppiness

Choppiness of Price Action

There are times it suffices to enter trades into the direction of price flow to make money (by taking profit or trailing the stop) regardless of indicators or patterns the price may paint. That's the rule of trendiness - at whatever point you enter, it's more probable the price will do what it's been doing than to reverse. At times like this, any trend following method will work: break-out systems, continuation systems, any kind of moving average crossover or swing systems. It looks hilariously easy - enter and take profit, in the rare case the price reverses, take a small loss. But what looks more hilarious is how traders get quickly used to these conditions, build expert advisors based on them, create rules and invincible methods which are soon about to die, as the price action adopts a choppy character.

Over the past few decades, price trendiness in the markets has been steadily decreasing, while the choppiness of the price has increased. The main reason for this is that the markets are more liquid; world's financial sector is at its peak, markets have now global character. There are more brokers and traders than before, more time frames are traded - all this is underpinned by the computerisation of the trade. Think about quantity: two voices can be clear and their sound dynamics very powerful. Two hundred voices produce more noise and sound dynamics are flatter. However they try, they will never adopt tunes as one voice.

What is choppiness? It's not volatility; it has nothing to do with ATR readings. It's not the direction of the market; market may go down, go up or sideways, while price may be linear or choppy regardless. Choppiness is the ability of the price to overlap itself. Interestingly and significantly, now when the trend is rarer, most common and popular indicators evolve around trends and swings : RSI, Stochastic, Macd, Zigzag. All brokers make them available. Now when understanding the price choppiness becomes the key to beat the price action, adequate indicators are as rare as a success without breaking the law and committing crime. Probably the best use for today's technical analysis was before it became popular, which was a few decades ago.

Choppy Markets Trading

My favourite indicator to measure the choppiness of the price is Choppiness Index developed by E. W. Dreiss. It's downloadable from the web and easy to install on platforms which support custom indicators. Although indicators are useful, everything they indicate is already in the price. Also, using Choppiness Index one becomes familiar enough to realise what it measures and to quickly involuntarily calculate it without looking at the indicator window. Anybody can roughly measure the degree of price overlapping just by looking at the price readings, the result may be more precise than any indicator. The key is to be aware and to pay attention.

MA crossovers are very popular swing methods which won't work in choppy markets. Some will give very nasty signals, some will keep losses in check, some may give moderate results. The key is to stop using those methods in choppy conditions. Don't count on a change, wait for the change to come. The choppiness of price vary throughout different time frames. Hourly and daily charts are still easy to play trend following. 15m are difficult at times, especially in currencies. 1m charts became impossible to trade positively without a filter, as the market oscillate between choppy waves or ranges and fine 'one line' trends with a few counter waves. This is probably why many small time frame traders moved to larger formats as their results worsened.

The chart above shows trading 1m DJ ma crossover (5ema and 20ema) using Choppiness Index as a filter. The crossover is not valid when CI 14 is above 44 and flat, valid when CI 14 approaches 44 from above or is below - pointing down. Also the crossover becomes valid when CI gets 'friendly' shortly (1-2 candles) after the crossover : I believe one could trade 1m DJ by entering into the direction of price every time CI 14 hits 44 from above.

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