TRADING TECHNIQUES
Ever Use The Phrase "It Depends"? Well, It Shouldn't
Normalization
by Brian R. Bell
Sometimes it can be hard to understand all those twitchy indicators on your trading screen. Here's how most of them generate useful signals with normalization, which is the process of removing the dependency of something on something else and making it stand alone.
Purely theoretically, suppose you're using the relative strength index (RSI): Sell when the RSI crosses below 75, and buy when the RSI crosses above 25. Also purely theoretically, suppose you also use signals based on a simple moving average oscillator: Sell when the oscillator crosses below a value of 50, and buy when the oscillator crosses above a value of -50.
FIGURE 1: RSI VS. MOVING AVERAGE OSCILLATOR. Given the proper conditions, a simple moving average oscillator can give signals nearly as well as RSI.
Figure 1 shows both of these indicators applied to a daily chart of lean hog futures, the moving average oscillator in the middle graph (N1 = 4 periods, N2 = 8 periods) and the RSI (N = 5 periods) in the lowest graph. The blue arrows on each indicator show where the buy signals occurred and the red arrows show where the sell signals occurred. The point? Both indicators give useful signals.
Figure 2 shows the same indicators, except now they are applied to soybean oil futures. The RSI rules provide a comparable number of signals, as before, but now there is not a single signal given by the moving average oscillator rules.
Why does this happen? The RSI is normalized, regardless of the instrument to which it is applied; its values will always remain in a range between zero and 100.
The moving average oscillator, on the other hand, is unnormalized. It is expressed in units of price and is affected by the amount of price movement. Thus, its range of values will vary based on the instrument to which it is applied.
WHAT IS NORMALIZATION?
Normalization is the process of removing the dependency of our indicators on, in most cases, the value of the price.
An indicator like the simple moving average oscillator is dependent on several things: the range of prices of the instrument to which it is applied, recent volatility, and average price levels. When you create an indicator, you need ways of normalizing it so you can apply it to different instruments, in different time frames, and in different periods of volatility. Here are four different normalization techniques that can be applied to your indicators. Here, I use the 4/8 moving average oscillator as an example:
- Normalizing to average price
- Normalizing to standard deviation of price
- Normalizing to average true range of price, and
- Normalizing to the range of the oscillator itself.
Brian R. Bell is president of Custom Trading Solutions, a consulting firm that specializes in implementing indicators and trading systems for use with CQG for Windows. He may be reached via his Website at https://www.customtradingsolutions.com, by E-mail (bbell@custom trading solutions.com), or by phone at 303 730-3388.
Excerpted from an article originally published in the October 2000 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2000, Technical Analysis, Inc.
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