Breadth Divergence Oscillator (BDO)
It is very important to read what others are writing as a source of profitable ideas. In my case I am looking for concepts or theories to use to build indicators or statistical models. One post particularly caught my eye because it inspired exactly that kind of idea : http://blog.afraidtotrade.com/may-2008-the-last-time-we-saw-major-breadth-divergences-like-this/ Corey Rosenbloom is a well-known technical analyst and trader who provides market analysis and often gives a theoretical explanations for his interpretation. It is this kind of analysis that is completely distinct from the vague and untestable technical analysis of the past. This kind of analysis can be molded into an experiment, or in this case into a technical indicator.
The basic concept here is simple: when the market rises but market internals (ie advancers or advancers vs decliners) are deteriorating, this should be negative for the market on the premise that there is very little broad-based interest in the recent move. The reverse applies when markets are falling but market internals are improving which should be bullish for the market. Looking at Corey’s post, the first thing that struck me was that he drew a line……..implying that we should be looking at the “slope” of advancers or advancers vs decliners, and also the “slope” of market prices. This immediately spawned the idea for the BDO- I could easily measure this effect using a technical indicator. The BDO is a direct measurement of the scaled differences between these two slopes. In this case after performing some normalization procedures, I looked at the slope of my own little advance decline line over the last 10 days vs the slope of the market. Readings below .3 show the classic bearish divergence, while readings above .7 show classic bullish divergence. How did this simple indicator perform? It was remarkably consistent over the last 40 years, which demonstrates the durability of good concepts–something I have tried to emphasize many times. Lets take a quick look:
|BDO on SPX Last 9000 bars|
|BDO on SPX Last 3000 bars|
As you can see, the effect is very consistent. There is very little disparity in the edge over the last 3000 bars versus the last 9000. The market makes no progress when BDO is less than .3, and the returns tend to be more slightly more erratic. In contrast, the market makes strong returns (note buy and hold made .97% over the last 3000 bars, and 7% over the last 9000) when the BDO is greater than .7. Using other indicators in conjunction with the BDO make the results much better, but that is a topic for a separate post.