The Damping Index
by Curtis McKallip Jr.
Variety is the spice of life — except when you're trying to optimize a trading system. This new indicator
identifies those places on the price graph where highs and lows are getting closer and closer together,
and when used in conjunction with buy rules and sell rules, it can be used to create a computerized
trading system. Longtime S&C contributor Curtis McKallip demonstrates.
Why is it so difficult to optimize a trading system for different markets? One reason may be that most
technical indicators are not easily related to classic economic theory. Designing a trading system becomes
not unlike designing an airplane without understanding aerodynamics. You might come up with a design
that flies better than another, but not knowing why it does so makes it difficult to translate that success
into other designs.
You can relate price patterns to supply and demand curves, even though you may not have all the
necessary fundamental data. Those curves are still active; they don't depend on data for their existence.
Rather, they are the stuff that markets are made of because they depict human behavior.
When a news event is reported, particularly an unexpected one, the price reacts and then settles down in a
zigzag pattern (Figure 1). The price versus quantity chart is known as a cobweb chart because of its
appearance. Normally, the equilibrium price of a tradeable occurs at the point where the supply and
demand curves cross. When a reported news event forces the price up without shifting either curve, that
causes the market to supply more of the product than it needs (or less if the price is forced lower). Since
the demand is not sufficient to account for all these products, the price drops below equilibrium, which in
turn causes producers to cut back on production, producing less than necessary. When the supply drops, the price goes back up.