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Filter function in HMA crossover

September 3, 2009

One of the readers(+followers) of my blog(twitter), Narasimha, (@narasimhagm), asked me how did the filter function work in the last post (“HMA Crossovers“)actually. More specifically ,his query was for the short side of the market, shouldnt the filter have been modified as the difference between Lowest Low of the Previous n bars minus EMA.

The issue, is yes, you can use symmetry, but I in my iterations realised it on the contrary decreases the system efficiency. Why. Dont ask me. But that doesnt justify my use of the same filter which I used on the upside even for the downside (at least at the first glance). But wait, it does!

Have a look at the (amateurish) picture I designed showing the phenomenon in both upside as well as downside.

An exhibit explaining the filter function in upside as well as downside mkts

An exhibit explaining the filter function in upside as well as downside mkts

Notice, irrespective of  the direction the market has broken, upside/downside, the difference has consistently increased. There are two reasons for this,

a. EMA is less sensitive and has a non zero lag between taking shock(a breakout) as an input and its response.

b. What we are getting as the difference, you can imagine it as a “detrended” signal. In usual circumstances, detrended price will give a total mean reverting signal. Here detrended high (if I may dare say), is increasing monotonically, which shows that indeed there is a trend (or the series is having time varying variance)


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