Drawdown Oscillator (DRO)
One of the complimentary concepts to the recent indicators and also fractals is the drawdown oscillator. This oscillator shares some similarity to the ulcer index, but has some unique departures. The drawdown oscillator is separated into two separate indicators: 1) DRO long which measures the drawdown from a long position 2) DRO short which measures the drawdown from a short position. The basis of the drawdown oscillator is the Donchian Channel: http://en.wikipedia.org/wiki/Donchian_channel. The Donchian Channel is used to define whether you are in an uptrend- hence favoring long positions, or in a downtrend- favoring short positions. The default parameter for the DRO is 50-days, but can be employed with any length depending on the dominant cycle length of the security.
DRO long is calculated as follows:
1) the DRO long is calculated only in uptrends as defined by Donchian channel long signals
2)take any drawdown that starts from a 50-day high and record the maximum drop in terms of ATRs or % return
3) record the last 20-100 drawdowns
4) take the percentile ranking of the current drawdown as measured in ATRs or % return in relation to the last 20-100 drawdowns
DRO short is the opposite of the DRO long in that it is based upon Donchian Channel short positions and is calculated from 50-day lows. Everything else in the calculation remains the same.
This oscillator is highly versatile and give you a different slant on overbought/oversold indicators. Its best application is for intermediate entries within a long-term uptrend– it is typically a 5-30 day trade. One would wait for the DRO to hit high levels without breaking the long-term uptrend as defined by the Donchian Channel. Once you hit a level above 75, you can set a stop loss at the channel bottom and set your first profit target at the channel top. A second part of your position can be retained to ride the trend. Your reward/risk on the trade is defined by the distance from the current price and the channel top versus the current price from the channel bottom. Theoretically, you should win on greater than 50% of trades, and if your reward to risk is high then you should have a very profitable situation. There are a lot of interesting variations on this concept that can produce very profitable strategies.