Technical Analysis Basics: The Detrended Price Oscillator (DPO)
Detrended Price Oscillator (DPO) — is a technical analysis tool invented to remove the influence of the general Market Trend from the price action and make it easier to identify cycles. It is not a momentum indicator, it’s used to identify high and low points within the cycle as well as to estimate its length.
Why do we need to remove Market Trend from price?
This is necessary to identify and isolate the short-term cycles.
I will start from the basics, saying Market Trends we mean:
- Bullish — an upward moving market characterized by increased buying pressure;
- Bearish — a down-mowing market with increased selling pressure;
- Sideways — a market with no visible trend. Trading usually occurs between the support and resistance areas;
- Reversal — market with a clear direction which suddenly changes to the opposite one.
DPO is not typically on the same level with current prices, it’s offset to the left (to the past) which helps to remove the current trend. DPO is not a momentum oscillator, it measures prior prices against a Simple Moving Average(SMA) in order to measure a cycle’s high/low range and the typical duration.
Moving Average (MA)- is a price based reactive indicator which shows the average price of a security over the chosen period. MA is a good way to confirm trends and define the support and resistance areas. There are a few different types of Moving Averages, the most notable are the Simple Moving Average (SMA), the Exponential Moving Average (EMA) and the Weighted Moving Average (WMA):
- SMA — is an unweighted Moving Average. Every day the data set has similar importance and is weighted equally. As each new day ends, the oldest data point is dropped and the newest one is added to the beginning.
- WMA — is similar to the SMA, except it adds significance to more recent data points. Each point within the period is assigned a multiplier who changes the weight or significance of the particular data point. Once a new data point is added to the beginning, the oldest data point is deleted.
- EMA — is s a type of WMA. The main difference is that old data points never leave the average(old data points retain a multiplier) even if they are outside of the chosen data series length.
Let’s get back to DPO:
The main purpose of DPO is to analyze the historical data in order to observe the cycle’s in a market’s movement. For technical analytics, DPO gives a better sense of a cycle’s high/low ranges and its duration.
How to calculate the Detrended Price Oscillator?
The DPO is calculated by subtracting the simple moving average over an “n” day period and shifted n/2+1 days back from the price.
- Decide on the bewished time frame to analyze.
- Set “n” as half of that cycle period.
- Calculate a SMA for n periods.
- Calculate (n / 2 + 1)
- Subtract the moving average, from (n / 2 + 1) days ago, from the closing price
(Price of (N/2 + 1) periods ago) — (N Period SMA) = DPO
The indicator is especially useful when trading on shorter time frames. Not being interested in long-term trading, you might want to exclude lasting trends from your estimates and only consider shorter fluctuations. For this purpose, there is no tool better than DPO. If it is your case, take a brief look at the DPO before opening the deal and you will know to what extent the prevailing trend is responsible for the price change.
Now, let’s sum why DPO can be really useful:
- For measuring the distance between peaks and troughs in the price/indicator.
- If troughs have historically been about two months apart, that may help a trader make future decisions as they can locate the most recent trough and determine that the next one may occur in about two months.
- To find the estimated future peaks as selling opportunities or the estimated future troughs as buying opportunities.
- The indicator is typically set to look back over 20 to 30 periods.
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