Indicators - Ehlers Dominant Cycle

If you haven't had a chance yet, you need to read "Cybernetic Analysis for Stocks and Futures: Cutting-Edge DSP Technology to Improve Your Trading" by John Ehlers.  It is an incredible read, especially for someone like me with an engineering background.  He clearly lays out the development of some novel indicators and also includes the easy language code.

One of the indicators he developed was the dominant cycle indicator.  The dominant cycle indicator measures the period length of the dominant frequency cycle.  The values general range from 10 to 40 periods and works on any time frame.  There is some inherent lag in the calculation, which I believe is about 8 bars.  Regardless, it is the fastest (shortest lag) calculation of the dominant cycle.  Below is a screen shot of the indicator.

As I mentioned before, the indicator does cycle quite a bit from 10 to 40 periods.  The only issue is the indicator is backward-looking.  So when the cycle period is large (around 40), a trend has already occurred and it may be too late to capitalize on it.  There are some very effective ways to use the indicator though.  A mean reversion type trade is a possibility.  Actually, it would be more of a breakout system.  You would plan to enter a trade at the beginning of a trend when the dominant cycle is low (around 10).  Of course you would need some other entry signals to confirm the initiation of the trend.

Using the dominant cycle to adapt common indicators is one of the more novel uses presented in the book.  Imagine using the RSI.  Instead of having a fixed period length, you could use the dominant cycle to make the period length adaptable.  The RSI would then use a smaller period when the cycle is smaller, or use a larger period when the cycle is larger.  You must be careful of the lag though because you could be out of phase with the data if the period is small enough. The possibilities are endless though and this indicator makes for a good launch pad for adaptable indicators.

I have some interesting ideas on how to use this indicator to create a better moving average and stop loss system.  I will do some research on the topic and present the results when they are ready.