MAX DIFF MODEL

Kirkpatrick & Company, Inc. New Relationship between the DMI and the trading market The DMI and ADX, products of Welles Wilder’s inventive mind, have been for me an excellent source of information on trading market behavior.

The basic calculations use all of the principal aspects of a bar chart: the high, low and close, and compare them over time to discern the internal strength or weakness of the price action. The actual calculation can be seen in my textbook or online at one of the many technical charting websites.

The portrayal of the three indicators, DI+, DI-, and ADX are lines on a price chart, usually colored differently for identification. In my charts, the red line is the DI-, the blue line is the DI+ and the green line is the ADX. The DI+ represents buying pressure on the security, and the DI- represents selling pressure. A crossover indicates the new dominance of one over the other pressure and thus a change in direction.

Because Wilder stated that the crossovers between the DI+ and DI- were important indications of trend change, and the stronger or higher each rose on the chart, the stronger the market in the direction of the dominant DI. The ADX was originally a measure of trend strength because it measured the difference between the two DI’s and had no directional bias. In my own work, I smooth the three variables (DI+, DI- and ADX) again with a simple moving average to take out the remaining “bumps.” Thus in any of my DMI systems, there are only two primary variables: length of lookback and smoothing factor. Wilder himself believed that the models with only two or three variables are the best. When more variables are added to account for errors in the results, the analyst is in effect curve-fitting. Once the variables and their parameters are established, additional filters can be added to fine tune the risks of poor entries and exits. In my work, I have used percentage stops from the entry price and multiples of the security average true range (ATR). I prefer to use percentage stops for both entries and exists. These are easy to calculate and adjust for the price of the security.

While the DMI and ADX include only three lines on a chart, the number of combinations is huge. Not considering the actual level of the indicators, which I believe is useless information, the possibilities of trend, crossovers, spreads, and reversals seems overwhelming. At first, as suggested by Wilder, I concentrated on crossovers in the DMI. By definition, a positive crossover with the DI+ exceeding the DI- is a sign of an upward trend. This method worked well once the parameters were established and was profitable. I then noticed that the ADX tended to peak coincident with an important price reversal and that it didn’t make any difference whether the reversal was a bottom or top. The ADX thus became an exit strategy and with filters seemed to lead the DMI crossovers. Each of the models designed around the DMI and ADX included filters, and after lengthy experimentation, the ones that seemed to work the best were an entry

Charles D. Kirkpatrick II

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August 9, 2016

Kirkpatrick & Company, Inc. filter (a percentage or multiple of the ATR added to the crossover bar) and ADX exit filters (a percentage the ADX had to reverse to confirm a peak and a percentage the security had to move once the ADX had a proven peak). To establish models based on the DMI and ADX, using all the variables and possible parameters produced an unwieldy series of calculations that probably approached the dreaded curve-fitting extreme.

These models using the DMI crossovers and the ADX have been the mainstay for my timing models until just recently. Observing two aspects of these models, I found that the ADX was useful for signaling the end of a trend, but unless it was tuned very closely to the price action, it could give premature signals and had difficulty returning to a position when the trend continued. Second, the DMI crossovers were always late, sometimes so late that they whipsawed positions. The net of this was that I looked again at the DMI and decided that since the ADX is comprised of the net of the DI+ and DI-, I should focus on each to see if they foretell market direction changes. I found they didn’t necessarily anticipate but could time changes almost immediately after a trend reversal, enough to give a very early signal for action.

As an example, look at Figure of the TYX. You will notice that the DI+ and DI- oscillate about each other and look somewhat similar to a two-dimensional representation of a DNA double helix. You will also note that the peaks and valleys of each appear close to opposite of the other. In other words, a peak in the DI+ occurs very close in time to the valley of DI-. And these peaks and valleys coincide with the respective peaks in valleys in price. When the price forms a top, the DI+ peaks while the DI- forms a valley. Thus if we can determine with a certain amount of accuracy that the DI+ has peaked and the DI- has bottomed, we know that a top in prices likely has also occurred. From that knowledge we can, through filters, establish when to sell short. The opposite, of course, is also true that when the DI- peaks and DI+ bottoms a price bottom has occurred. Because the DI respective peaks and valleys occur at roughly the same time in opposite directions, the difference between these is the number to watch. When it reaches its maximum and turns, a peak or valley has likely occurred. To minimize the errors from minor and false reversals, I use a price filter to confirm that the reversal is reflected in the price as well as the DMI. Filters are used at three different junctures, once on the entry from the model signal, and twice on price reversals thereafter. When, for example, the DI+ is higher than its previous reading and the DI- is lower than its previous reading, we can estimate that the price is rising.

When the DI+ reverses downward from its previous reading, and at the same time the DI- turns upward, we can assume a top has been made in prices. Should the price decline by a specified amount, called the “entry filter,� we sell short. A separate price filter therefore exists for both tops and bottoms. We can then run the series knowing that price tops and bottoms can be identified as each long or short the filter is triggered. This simplified version of the Diff system is a stop-and-reverse (SAR) system that is always in the market, long or short.

Charles D. Kirkpatrick II

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August 9, 2016

Kirkpatrick & Company, Inc. The second type of filter is the exit filter. These come in many forms but are usually broken down into protective and trailing filters. A trailing filter, such as the Chandelier Exit based on volatility, follows the security and exits on a price reversal based on the Chandelier formula, thus saving profits. The protective filter provides a defense against a move contrary to the entry price. It protects initial capital. After numerous experiments with filters, in the DMI Difference model, I have found the simple percentage change from the entry price is the best safety net without getting too complicated. A different percentage is used with longs and shorts, however, because a declining market behaves differently than an advancing market. In experimenting with this concept, I have found that in all cases, using the measure of return versus drawdown, performance is always better when different figures are used for long and short positions. If during experiments with separate percentages showed a common percentage for both, we could assume a single percentage would be sufficient, but this is never the case when percentages are studied individually.

One interesting phenomena that occurred in the testing of the Diff model exits was that performance improved when the exit percentage was triggered and a position in the opposite direction was entered. This behavior may appear intuitive in that an established position when it goes badly suggests that opposing directional forces are acting on the security and that the position should therefore be reversed. In these instances, the exit filter, i.e. a sell stop in a long position, in addition to closing the long position would also be a short sale signal to enter a short position. Of course this method can carry on indefinitely with filter breaks causing multiple longs and shorts, and must be stopped at some time. Through experiments, I determined that two filter reversals were the maximum before closing all positions because the number of test samples shrunk, and the accuracy of the percentages out three turns became suspect and produced random estimates in the optimizations. Nevertheless, the position reversal in both the first and second reversal provide increased returns. The percentage used for the first reversal and second must be determined through optimization because they are generated by different forces.

Each security model Diff formula, therefore, ideally has eight variables: the length of the DMI calculation, the length of the moving average that smooths the DMI results, a percentage for longs and shorts individually for entry after the model signal, and two sets of exit filters for the first reversal and also two more separate sets for the second reversal. In some optimizations, the second reversal filter parameters become random, and the second filter is then dropped from the model. If you wish a copy of my TradeStation program for the Diff model, let me know. Be aware, however, that I am a tinkerer and may change aspects of the program later when I see opportunities to improve its results.

Charles D. Kirkpatrick II President kirkco@capecod.net

Charles D. Kirkpatrick II

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August 9, 2016

Kirkpatrick & Company, Inc. EXAMPLE USING HOURLY NASDAQ 100 FUTURES

The large humps in the DI+ v. DI- signify a turning point in price. At the bottom on August 2, for example, the DI- was far above the DI+ and both reversed at the price low. The same occurred in August 5 when the DI+ was far above the DI- indicating, when the line begin to reverse, that a price top was forming. Minor humps also coincide with shorter turning points but are more difficult to trade. Sometimes the lines form a hump but fail to cross as on August 4 when the DI+ declined to the DI- and then abruptly turned back upward. Signs of strength such as this provide opportunity.

Charles D. Kirkpatrick II

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August 9, 2016

Kirkpatrick & Company, Inc. Equity Curve of NQU16 hourly trading using the MAX DIFF model:

Notice how the profit advanced in steps. This is the ideal for systems where profits are accumulated when the model catches a trend and the portfolio becomes flat during times when the model cannot operate. It results in a minimum drawdown, and profits only when the model is picking up impending trends.

Charles D. Kirkpatrick II

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August 9, 2016