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Making profitable use of chaos theory in the markets has been an enticing but elusive goal for many traders. E.W. Dreiss has developed the Choppiness Index using chaos principles to measure market trendiness.
The science of chaos has piqued the imaginations of traders looking for an edge in the markets. Since Benoit Mandelbrot, a pioneer in chaos theory, did some of his early analysis of the cotton markets, traders have tried to find an application in the markets, but few have succeeded. E.W. "Bill" Dreiss, a commodity trading advisor based in Australia, has used concepts from chaos theory to construct a simple measure of the "choppiness" or directionality of the market, that is, whether prices are trending or are in a period of trendless consolidation. Several indicators already exist that perform a similar function. Welles Wilder's Directional Movement Indicator ADX is one of the oldest and most widely known. More recent new indicators of this type are the Random Walk Index, created by Michael Poulos of Trader's Insight and Adam White's Vertical Horizontal Filter. With the "Choppiness Index" (CI) Dreiss measures something akin to the "fractal dimension" of the market. Conventional Euclidean geometry describes geometric figures in terms of dimensions. Two points in space define a line, and a line has one dimension--length. Three points not on the same line define a plane which has two dimensions-- length and width. Four points not on the same plane define a space which has three dimensions--length, width and depth.
New paradigm
Chaos theory says the real world is not so neatly Euclidean. While standard geometry has proven useful for measuring and quantifying the world around us, it falls short in critical areas and leads to paradoxes. Chaos theory provides a new "paradigm" for viewing the world that may be more useful. It says. among other things, that objects don't necessarily have an integral dimension, i.e. whole numbers like one, two, three or four. Rather, real world objects are more likely to have fractional or fractal dimension which may be 1.37 or 2.89.
Market prices provide a good example of fractal dimension. When prices are plotted over time on a chart, the resulting figure is by no means a one dimensional straight line. Nor is the figure fully two-dimensional because it does not cover an area as such. However, the market exhibits times when its movement is more linear (when trends appear), and other times when its movement is more plane-filling (choppy consolidating periods). The dimension of the market price through time falls on a fractional number somewhere between one and two dimensions.
Dreiss employed this concept when he created the Cl to measure the trending characteristic of the market. Higher index readings indicate the market is more choppy with fewer identifiable trends (which correspond to a fractal dimension closer to two); lower numbers indicate market prices are moving in a more linear or trendy way (and have fractal dimensions closer to one). The index can be used as a measure of market risk or volatility in a way that is easy to calculate. simple to understand, and well-behaved (well bounded) on the numerical scale. The CI measures the relationship between the sum of daily trading ranges during a given period of time against the total range for that period. To illustrate the concept look at the bar chart of IMM Deutsche mark futures prices titled "Choppiness Index in action". (page 52). We can draw a rectangle around a number of market days (say, 14, although other time frames can be used). The top of the box lies at the highest high during those 14 days and the bottom of the box lies at the lowest price low during the period. For example, the box drawn on the chart labeled "Choppy" highlights a period of consolidation corresponding to a high reading on the CI.
Ink blots
To understand the CI, think of the ratio of printed ink within the box to the total area of the box. In a market like ''trendy," there will be less ink in relationship to the white space (a lower CI reading). During choppy, trendless market phases, there will be more ink relative to the boxed area (higher CI). The CI is simply a mathematical measure of this relationship.
The Cl is not suitable as a stand-alone tool in a trading method per se; it is better as an adjunct to other methods. The Cl can be employed in conjunction with a trend following method to indicate periods when trades are less likely to be successful because there are no trends in the market. When these conditions are present, trades are filtered.
In the November 1991 issue of Technical Trader's Bulletin, Dreiss explains how he interprets the Cl: "Low readings in the Cl correspond closely with the end of strong impulsive movements either up or down, while high readings occur after significant consolidations in the price. Extended periods of trendless price movement are reflected in extended periods of above-average readings of the CI. One might assume that markets with high CI should be avoided and only markets with low CI should be traded. However, it is more likely that one would want to avoid markets with constant above-average Cl and trade markets where the CI swings from one extreme to the other.
As with many technical indicators that look at past data, the CI describes what has happened in the past, but isn't a crystal ball into the future. It may provide, however, useful information about impending changes in the current condition of the market. Dreiss says "high CI readings can be used to indicate that a consolidation is about to end and a position should be entered or a breakout anticipated." (Since the CI reading has nothing to do with market direction, it does not indicate in which direction to expect the breakout, but that the breakout will probably be followed by a significant move.) "Low CI readings can be used as a signal to take profits or tighten stops in anticipation of a market reversal or consolidation, or in some cases could be used to pick tops or bottoms." [FM]
A spreadsheet showing how the Choppiness Index is calculated can be found here:
HYPERLINK "ftp://ftp.io.com/pub/usr/gibbonsb/futures/pc/CHOPPY.XLS" ftp://ftp.io.com/pub/usr/gibbonsb/futures/pc/CHOPPY.XLS
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