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MESA8 The premise of MESA is that market cycles are the one characteristic that can be scientifically measured. The MESA (Maximum Entropy Spectral Analysis) algorithm makes a high resolution estimate of the entire range of potential cycles. Experience has shown that there is typically only one tradable cycle in the market at a time. This is the "dominant cycle" that is extracted from the spectral estimate by using a center of gravity approach so that the dominant cycle is the one containing the majority of the cyclic power. A real-world example of the spectrum as measured by MESA8 is shown in the following figure for the S&P Continuous futures contract for the year prior to November 2005. The spectrum is displayed as a heat map, running from white-hot, through red-hot, to ice cold over a 20 dB range. Colorizing the spectrum this way enables the spectrum to be displayed in time synchronization with the price data.
MESA8 Spectral Esimate for the S&P Continuous Futures Contract for the Year Prior to November 2005 Notice that the dominant cycle is ephemeral - it comes and goes, sometimes very quickly. MESA8 provides the dominant cycle as an output that enables other indicators to be adaptive to current market conditions. The dominant cycle indicator also enables you to smooth the dominant cycle with any degree of smoothing you desire. Since there is typically only a single tradable dominant cycle present at a time, a simplified model of the market consisting of just a trend and a cycle seems reasonable. With this, we can build trading strategies based on the premise of a trend mode and a cycle mode. The trend is just the difference between the current price and the price one cycle period ago. Since the cycle period is known, we therefore know the trend. The trend can be measured by taking a Simple Moving Average whose length is the period of the dominant cycle. This completely removes the cycle component because there are as many sample points above the average as below the average - thus the trend component is revealed. However, taking the Simple Moving Average introduces a lag in the trend equal to half the dominant cycle period. If the trend is horizontal this is no problem, but does represent a distortion in both bull and bear trends. This distortion can be compensated by adding half the "momentum" across the cycle period to the Simple Moving Average. This compensation adds a vertical displacement which, in theory, compensates for the lateral displacement of the lag. The "instantaneous trendline" produced by MESA8 is shown in the following figure.
MESA8 Instantaneous Trendline and Detrended Data Computed this way, the instantaneous trendline forms the mean value of the prices, around which the cycle component swings. The detrended price is computed by subtracting the instantaneous trendline from the prices. In the figure above, MESA8 scales the detrended price to the +1 sigma and -1 sigma values for you to easily visualize when the prices can be expect to revert to the mean. Trend Mode or Cycle Mode? See our "Trading with Cycles" page for a more complete description. It is not advisable to trade cycles if the cycle amplitude is swamped by the trend or if the signal to noise ratio is so low that profit expectation is diminished significantly. In MESA8 we accurately measure the cycle period, show the cycle and instantaneous trend components. We also consolidate the conditions under which one should trade the cycle mode or the trend mode of the market. The following figure shows these components in a real-world example of the 30 Year Treasury Bond Continuous Contract for the year prior to June 2005.
Trading Mode The first subgraph below the price bars shows the trend slope as the red line, superimposed on the (plus and minus) amplitude of the cycle component show in yellow. One would want to trade the cycle mode only when the red line is contained between the two yellow lines. The second subgraph shows the measured signal-to-noise as the cyan line relative to the white 6 dB threshold line. One would want to trade the cycle mode only when the signal to noise ratio exceeds 6 dB. The third subgraph clearly shows when to trade the trend mode (when the indicator is high) and when to trade the cycle mode (when the indicator is low). Cycle Quality Returning to the cyclic component, the figure below shows several aspects of MESA8. The first subgraph shows all the cycle components in the data by highpass filtering (passing all the cycle periods shorter than 50 bars) as the red line. The second subgraph shows the bandpass filtered data as the violet line, where the center of the passband is tuned to the dominant cycle. Note the two curves a similar near the time center of the chart. The third subgraph displays the RMS error across the dominant cycle period in terms of decibels from 0.1%. The error is the difference between the all the cycles and the bandpass filtered cycle. Errors greater than 0.1% are shown in red and errors less than 0.1% are shown in green. The error can be another way to judge when to trade in the cycle mode.
MESA 8 Cyclic Indicators Leading Indicator In calculus the rate of change d((Sin( w t))/dt = w *Cos( w t) means that the derivative of a sinewave is the angular frequency times the cosine wave. In other words, the derivative is just a scaled version of the original waveform advanced by 90 degrees (a quarter of a cycle) in phase. In sampled data systems the rate of change is approximately the one bar momentum. So, if the market is in a cycle mode and we know the frequency of the cycle (by virtue of the MESA measurement), we can advance the phase of the indicator by 90 degrees to form a leading indicator. That's what this indicator does by taking the momentum of the narrow bandpass filter output. A convenient trigger is also provided. It is just a scaled version of the indicator delayed by one bar. Non-Causal Leading Indicator The problem with virtually all indicators is that they are causal. That means they directly depend on data for their computation. As a result, the computation cannot be accomplished until after the data arrives, and - as a result - all causal indicators have lag. Lag is perhaps the traders' worst enemy, particularly when trading the cycle mode when relatively short term entries and exits are expected. MESA8 offers a solution to the lag problem by offering the Sinewave indicator. The market is coherent in the cycle mode, meaning that the dominant cycle has existed for a short while in history. It is further assumed that the dominant cycle will continue for a short time into the future. Since the dominant cycle is known, and its phase can be computed, we can advance time by advancing phase of the coherent dominant cycle. The Sinewave indicator shown in the figure below is computed using the phase of the dominant cycle. The Lead Sine indicator is computed simply by advancing the phase of the dominant cycle by 45 degrees. This creates an indicator that produces a crossing signal 1/8th of a cycle ahead of its turning point. For an 16 bar cycle, the crossing occurs 2 bars ahead of the cyclic turning points - just right for making a timely trade entry. Clearly, the Sinewave indicator does not work so well when the market is in a trend mode.
MESA8 Sinewave Indicator The MESA8 program uses TradeStation's probability map to display a prediction 10 bars into the future. The prediction uses both trend and cycle mode components to make a startlingly accurate prediction of future price movement. As shown in the figure below, the prediction can be backtested for any bar on the chart. The prediction is located at the center of the chart and clearly shows the expected cyclic turning point about 8 bars into the future.
MESA8 Backtested Prediction The momentum taken across the dominant cycle period is one component used to compute the instantaneous trendline. This momentum, including its rate of change, is also an excellent measure of the strength of the trend. Momentum is included as MESA8 indicator. Further, the momentum is used to create a trade heatmap to guide your trading. The MESA* trade heatmap is shown in the graph below. The objective of the heatmap is to provide visual reinforcement for trading decisions for discretionary trading. We have intentionally "fuzzified" the indicator to avoid the black-or-white decisions of most computer generated trading signals. Green is a strong long position. Red is a strong short position. and various shades of yellow are the equivalent of a shoulder shrug.
MESA8 Trade Heatmap We have attempted to describe all the major features of the MESA8 Package, built as a plug-in into the TradeStation platform. We are sure you can use some, if not all, of the features to your trading advantage. At a minimum, you will not be looking at the market the same way ever again. You are bound to abandon your tired old Stochastics, RSIs, and moving averages. |
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