Trend Strength Index (TSI)

Stocks and markets change constantly, and their behavior needs to be classified in a reliable way to adjust your trading strategies accordingly. We need a way of measuring things so that we can adjust our strategies based on a change in some measure that is predictive of future behavior. For example, we know that human beings have an internal temperature of 98 degrees–under this circumstance, a person behaves quite normally. However, shift that temperature up to 104 degrees and that same person will behave very differently. If we shift that temperature to 93/94 degrees, a similar radical change in behavior is observed. More importantly–and this has subtle implications–under most circumstances these shifts in temperature are caused by some environmental influence, and once the environment changes a person will return to stasis at 98 degrees. The body temperature can also help us differentiate between different species–for example biologists make the distinction between warm-blooded and cold-blooded animals that have different behavior as a function of temperature. What we need for the stock market is some absolute measure that helps us predict a change in the behavior for stocks/markets, and also a means of  classifying different species/markets.

I often discuss theories and ideas about markets with other people, and one person that I have had several discussions with in recent times is Frank Hassler of the blog Engineering Returns http://engineering-returns.com/2010/06/28/aapl-ts/ Frank is a very intelligent and also very diligent researcher that likes to research any and all ideas–a trait that I definitely respect. Frank was inspired by some of the research introduced on the LTR (Livermore Trend Ranking) and the necessity for classifying stocks as either mean-reversion or trending. In the course of his research, Frank was generous enough to share one of the indicators that he created that he calls the TSI- for Trend Strength Index. The TSI is an intermediate-term absolute (versus relative ) measure of the tendency of a stock to trend or mean revert.  The premise underlying the theory is that stocks with a high degree of momentum in relation to volatility are much less likely to mean-revert than those that have a low degree of momentum in relation to volatility.

If you think about stocks like Apple Computer, they do not exhibit much choppiness in relation to the strength of their overall trend. This is what makes them difficult to trade counter-trend since a) they have fewer opportunities/fewer pullbacks or ralles b) the few pullbacks/rallies are either immediately followed by higher or lower prices in the direction of the trend, or an abrupt change in the trend altogether. In contrast this makes them much easier to trade with the trend, since the reward relative to uncertainty is higher in most scenarios.  Tommorow, I will introduce the formula for the TSI and also some results. This indicator is highly useful at determining which  stocks to trade with the trend, and which stocks to avoid trend trading in favor of a mean-reversion strategy. The TSI can also be used as a measure to apply to the same stock as a trend filter.

to be continued………..