Recently I have been experimenting with a new concept I came up with. One thing that really bugged me about moving averages, and all indicators that used moving averages internally (which is a lot, like Bollinger Bands etc), is that often the data is thrown off because of a spike in the market.
The classic case is when using Bollinger Bands as a volatility indicator, and there isn’t much volatility so the bands are tight, then suddenly out of nowhere the price spikes a bit causing the bands to widen and you are left not really knowing what to do. Something like below:
When it comes to reversion strategies, this kind of thing really defeats you. You can see that just after 21:10, the market retraced back down. An opportunity that may have been seized if the Upper Bollinger Band wasn’t all whacked out from the price move earlier.
What if we could write an indicator that was smart enough to ignore spikes? Well, we can never completely ignore spikes because the market does move with the spike, and if we completely ignored it, we would be simply left behind.
So, what if we could write an indicator that could handle these spikes better, perhaps reset its calculation from that point on instead of being thrown off until the violating price move has gone out of range? Well, that is exactly what I developed. Introducing the Resetting Average.
In the above chart there are three indicators. A SMA (in the off yellow color), a BB, and my new Resetting Average indicator. The Resetting Average Indicator acts like a normal simple moving average (SMA) but resets itself whenever a configured standard deviation level is reached. In this case, the level is 3.0. This is confirmed by the BB instance also being set to 3.0, and the average resetting whenever it touches the band. The result is a faster responding simple moving average that is less impacted by unusual price moves.
Taking this further, let’s apply the same idea to something like the Bollinger Band indicator. Same idea, when the price reaches a particular standard deviation level, reset the calculation. Introducing the Resetting BB indicator.
The above image is of the exact same timeframe as the original BB image presented in this post. Now, our bands are much tighter having reset itself once the price deviated too far. This may provide more accurate retracement signals, and indeed in the 21:10 example earlier, it has. More thought is required regarding the impact of such a change, but I am sure I can design a strategy around it and test the enhancements.