You Can Trade Clearly Now with ODI: One Problem with Traditional Indicators Is They Can Work Great in Some Markets, but Are Terrible in Others. However, If You Manipulate the Data before You Apply Your Analysis Tools, You Can Get a Clearer Picture

By Marczak, Chris | Modern Trader, March 2005 | Go to article overview

You Can Trade Clearly Now with ODI: One Problem with Traditional Indicators Is They Can Work Great in Some Markets, but Are Terrible in Others. However, If You Manipulate the Data before You Apply Your Analysis Tools, You Can Get a Clearer Picture


Marczak, Chris, Modern Trader


As times change, so do terms and definitions. And markets, which are projections of human behaviors, evolve along with their changing environments. To stay surfing on the tide, the trader must evolve as well, changing his ideas and tools accordingly.

At the time when we were building the fundamentals of an option trading strategy, we first needed a working definition of trend applicable for our purposes. After browsing through many resources, we realized that borrowing this concept from others was not going to be a satisfactory solution.

Because we wanted to sell options, our primary concern was to recognize which side of the market had a higher probability factor of success. Thus, our attention was taken to the molecular picture of the entity in question, in this case the market. We termed the molecules that make this molecular picture of the market "micro momentums"--basic movements that in the long term can move prices, markets, countries, nations and even the world itself. After that, it was just a jump to define elementary terms, which could help us to build a whole picture of market structure.

Market movements are quantitative (there is always some minimum tick) so we will explain market movement by quantum theory, rather than by wave theory. Watching this closer leads us to the simple concept that prevalence of positive over negative micro momentums (and vice versa) gives us exactly what we need: molecular definition of trend. Hence our definition goes as follows:

Trend is a market condition in which the absolute value sum of elementary directional momentums is greater than the sum of elementary directional momentums of opposite orientation.

[ILLUSTRATION OMITTED]

WHERE:

Elementary directional momentum is market momentum in a hypothetical basic time unit.

What does it mean and how to take advantage of this theory? There may be multiple ways, but in our case it was just as simple as this: We just need to measure total micro momentum deviations from the starting point until the end of a given period. For option sellers the most appropriate end of the tested period is the expiration date; however, considering that we often offset short positions before time expires, other time brackets can be used, as long we test periods of the same length.

To unify our calculations, percentage approach seems to be the most appropriate for such analysis. Thus, we calculate the following:

* H% -- percentage high deviation from starting point A till point B

* L% -- percentage low deviation from starting point A till point B

* C% -- percentage close deviation between close at point A and close at point B

Because we want to investigate the balance of the market, high/positive deviations would be calculated as positive numbers, while low/negative deviations come as negative numbers respectively. We can now define Total Periodical Deviation (DTP) as:

DTP = H% + L% + C%

DTP is a useful number. If the market overreacts during the tested period, DTP will show such change in respect to the final correction. During moderate periods DTP changes will reflect prevailing micro momentum action. To use it as an indicator of long-term prevailing trend, we need to smooth it out with an additional calculation. In this case, we'll use a simple moving average. The resulting smoothed value of the DTP is what we call our Option Deviation Index (ODI).

The general goal is to get rid of the maximum number of psychological movements so we have a core picture of market sentiment. By denoting this, according to our definition of trend, we obtain an analysis of the prevailing movement's geography. Such configuration is responsible for long-term trends and, therefore, it remains for a number of years before it changes.

Please note that there is significant difference between ODI and a standard percentage chart (see "Diagramming the ODI," right). …

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You Can Trade Clearly Now with ODI: One Problem with Traditional Indicators Is They Can Work Great in Some Markets, but Are Terrible in Others. However, If You Manipulate the Data before You Apply Your Analysis Tools, You Can Get a Clearer Picture
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