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How can I reduce indicator whipsaws?

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The chance of whipsaw increases as the speed of the indicator increases. Conversely, lag increases as the speed decreases. Chartists are always searching for the sweet spot between speed and lag. As far as indicators and settings are concerned, there is no holy grail. Moreover, the market is constantly changing. What works in a trending market will not work in a flat market. What works in a volatile market will not work in a docile market. When it comes to moving average signals, we can reduce whipsaws by applying a filter. Of course, this comes at the expense of a little lag.

Filters can be based on specific levels, time or both. A moving average could be filtered by adding a percentage-cross requirement and a time requirement. For example, a cross would not be valid unless price exceeds the moving average by 2% and holds that crossover for at least three days.

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Click this image for a live chart.

Chartists can measure this percentage cross using the Percent Price Oscillator (PPO). This indicator shows the percentage difference between two moving averages. A 1-day moving average would be equal to the close. Therefore the Percent Price Oscillator (1,50) would show the percentage difference between the 1-day EMA (close) and the 50-day EMA. Chartists can then add horizontal lines at +2% and -2% to identify crosses that exceed these levels. This article is not designed to show a winning system. Instead, it is just to show an example of how to apply a filter to moving averages.

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Click this image for a live chart.

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Arthur Hill
About the author: , CMT, is a Senior Technical Analyst at StockCharts.com. He has written articles for numerous financial publications including Barrons and Stocks & Commodities magazine. Focusing predominantly on US equities and ETFs, his systematic approach of identifying trend, finding signals within the trend, and setting key price levels has made him an esteemed technician. In addition to his CMT designation, Arthur holds an MBA from the Cass Business School at City University in London. Learn More
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