Price Direction Indicator (PDI) Detects Changes in Price Direction

The Upside is for Winners – Beware of the Downside shows that most upside buy and sell combinations are profitable and that most downside buy and sell combinations are unprofitable. Therefore, investors should buy on the upside and avoid the downside. So the next logical question is how do you know in real time whether prices are on the upside or on the downside? When you follow a price chart of rising prices in real time, how do know whether a dip in prices is a temporary decline of a few days or weeks or the start of a new prolonged downside? Similarly, for a downside how do you distinguish a temporary bounce in prices from a basic shift in the price direction from the downside to the upside?

To help answer these questions I (Richard Howard) developed the Price Direction Indicator (PDI), a simple to understand technical analysis tool that combines two variables to detect a price direction change from the upside to the downside or from the downside to the upside. The variables, the cumulative percent winners and the cumulative returns, are derived from the percent returns of buy and sell combinations contained in the trade table of the Complete Trading Model (CTM).

Cumulative Percent Winners

The cumulative percent winners are the proportion of all the buy and sell combinations that are profitable from the start of analysis to the current date of the analysis. The value of the cumulative percent winners is computed for each day of the price series. As prices rise on the upside, the proportion of buy and sell combinations that are winners quickly increases to eighty or ninety percent. For the downside the percent winners steadily decline as prices fall.

The cumulative percent winners lag the price series much like a simple moving average of prices lags its underlying prices. Therefore, the cumulative percent winners peak after prices peak or bottoms after prices bottom. This property means that if you use the cumulative percent winners as a buy or sell signal in real time, you would buy on the early upside and sell on the early downside.

Because the magnitude of the cumulative percent winners changes slowly from day to day, their trend is not changed by a few days of up or down prices. This property makes the cumulative percent winners immune from giving false signals of an overall change in price direction.

Cumulative Returns

The cumulative returns tells you the average percentage return for all the buy and sell combinations from the beginning of the analysis to the current date of the analysis. These values are predominately positive on the upside and predominately negative on the downside. The value of the cumulative returns is computed for each day of the price series. The cumulative returns are used with the cumulative percent winners to confirm a change in direction of prices. As prices move up, the returns for most trades is positive so the cumulative percent returns move up and eventually peaks. As prices begin to decline, the returns of most buy and sell combinations turn negative so the cumulative returns decline.

Cumulative returns peak or bottom after the cumulative percent winners peak or bottom. This lag builds in a wait-and-see time interval during which the actual upside or downside move of prices is established. Therefore, cumulative returns serve as a confirmation that prices have indeed changed direction.The cumulative returns, like the cumulative percent winners, are not too sensitive to brief changes in the underlying price direction. Once cumulative returns begin to increase or decrease, they stay on that path until prices rise or decline for many weeks.

The Price Direction Indicator (PDI) calculation sums the cumulative percent winners and the cumulative returns for each interval of a series series. For a daily interval the daily PDI value is the daily cumulative percent winners plus the daily cumulative returns.

With this calculation the date that PDI peaks will fall between the dates that cumulative percent winners and cumulative returns peak. Usually cumulative percent winners peak before cumulative returns.

To view the PDI values plot them on the same chart with the closing daily price for each day of the analysis. The magnitude of the PDI daily values is not important. It is their direction and pattern that tells you if prices have changed direction.

You can download the PDI computer program which computes the price direction indicator, cumulative percent winners and cumulative returns for each day of a selected prices series. The program was used to generate the results for the examples used in this article.

Using the Price Direction Indicator (PDI)

Kulicke & Soffa (KLIC), a semiconductor equipment maker whose prices follow a cyclical price pattern, serves to show how PDI is used to analyze the change from a price upside to a new price downside and then from the downside to a new upside. The first upside started on August 1, 1996 at $4.56 and peaked at $28.62 on September 11, 1997. The downside began on September 12 and ended on October 8, 1998 at a low of $5.19 and the next upside began.

Upside to Downside Analysis

The upside to downside analysis started with August 1, 1996 at $4.56, the first day of the upside. In real time you run PDI every day until you conclude that a change in price direction has occurred.

For the KLIC upside to downside analysis PDI peaked on October 3, 1997 just over two weeks after the daily close peaked at $28.62 on September 11, 1997. The cumulative percent winners peaked two weeks after prices peaked. PDI and cumulative returns peaked one week later.

In real time when the PDI curve turns negative for a few days or weeks, you may infer that prices have moved to the downside. How long PDI must stay negative for you to conclude the downside is in place is not a fixed time interval. An aggressive investor might say prices changed to the downside the instance that PDI moved down.

A more cautious investor would monitor the trend for weeks. The length of time you wait to conclude the downside is in place depends on your investing style. Obviously the longer you wait, the higher the likelihood you rule out a false start to the downside. But you'll sell at a lower price if the downside were for real while you waited.

Cumulative Percent Winners

The chart of cumulative percent winners for the upside to downside analysis of the Kulicke & Soffa price series shows the pattern of cumulative percent winners. The cumulative percent winners peaked on September 25, 1997 approximately two weeks after prices peaked.

For the first few months of the analysis the cumulative percent winners fluctuate widely due to computational anomalies associated with few buy and sell combinations. Because the cumulative number of buy and sell combinations is the denominator of the cumulative percent winners computation, a small number of buy and sell combinations causes exaggerated swings in the values of the cumulative percent winners. As the cumulative number of buy and sell combinations increases, the fluctuations dampen and the cumulative percent winners curve enters a distinct uptrend, peaks and then declines.

As the upside price move progresses, more and more buy and sell combinations are winners because most of the buy and sell combinations for the buys at low prices make money when sold at progressively higher prices. The same is true for buys in the middle of the upside. Most sales are at higher prices are profitable. Typically the cumulative percentage of winning upside buy and sell combinations exceeds ninety percent by the end of the upside.

Eventually prices peak and then start a new downside pattern. Now buys at relative high prices on the downside lose money when sold at lower downside prices. Also many buy upside at high prices near the end of the upside and sell downside combinations are losers. Therefore, as prices continue to decline on the downside fewer and fewer buy and sell combinations are winners so the cumulative percent winners decline.

Cumulative Returns

The chart of cumulative returns for the upside to downside analysis of the Kulicke & Soffa price series shows that the cumulative returns peaked on October 3, 1997 approximately three weeks after prices peaked.

Downside to Upside Analysis

To analyze the downside to upside price direction change you identify the bottoms for PDI, cumulative percent winners and cumulative returns. The following example is for the KLIC downside that started on September 12, 1997, the day after prices peaked. Prices bottomed at $5.19 on October 7 and 8, 1998.

Cumulative Returns

The cumulative returns bottomed on October 21, 1998 one day after cumulative percent winners bottomed.

Summary and Conclusions

You use the Price Direction Indicator (PDI) to detect major changes in price direction from the upside to the downside and from the downside to the upside. PDI always peaks or bottoms after prices peak or bottom. The cumulative returns peak or bottom after the cumulative percent winners peak or bottom. PDI peaks or bottoms on the same day of shortly after the cumulative percent winners peak or bottom.

You may use PDI, cumulative percent winners and cumulative returns to confirm buy and sell signals that you set using 20-day simple moving averages of price.

Read Cyclical Stocks: Making Buy and Sell Decisions to learn how to integrate PDI into your buy and sell decisions. And remember that your best chance to make money is to buy and sell on the upside.