Stocks & Commodities V. 31:2 (36-39): Chartmill Value Indicator, Part 2 by Dirk Vandycke

Chartmill Value Indicator, Part 2 by Dirk Vandycke

Under- And Overvaluation

In the first part of this series, you were introduced to an oscillator not prone to stickiness in overbought/oversold regions and that didn’t have the lag commonly associated with oscillators. In part 2, here’s how to apply it and profit from it.

When using the Chartmill value indicator (CVI), which is a short-term oscillator, I try to capture overbought and oversold setups. Based on a normalization procedure well-known to engineers and statisticians, the indicator’s construction makes for far different properties than those of most popular oscillators. To begin with, the CVI doesn’t have the stickiness that keeps other, range-bound oscillators in overbought and oversold zones while strong trends develop. Second, the lag typical for moving average–based oscillators is far less of an issue with the CVI. Finally, because of its adaptable dynamic nature, there are no parameters involved in its equation, so the CVI is totally objective by definition.

But it is still necessary to give it an objective interpretation. Let’s find out if this indicator is of any real and statistical significant usefulness.

Consensual value

In my previous article I introduced the CVI and how it is built. Because of its normalizing nature, it can be used in the same way for any time series. Any value between ‑4 and +4 indicates a strong short-term consensus regarding current pricing as fair value. Any value between 4 and 8 indicates slight overvaluation, while anything higher than 8 indicates plain overpricing in the short term.

Even though the CVI isn’t a range-bound oscillator, you will rarely see values higher than 8 with this indicator. Given that values for the CVI are next to never much higher than 9, this would indicate major overvaluation with respect to short-term consensus. In order to cope with the stickiness effect that plagues other oscillators, the CVI has a tendency to time-correct toward zero and considers new price extremes more normal as time goes by.

Likewise, minor undervaluation, in regard to short-term consensus, is defined as between ‑4 and ‑8 and plain undervaluation below ‑8. Any value lower than ‑9 would be considered to be a major undervaluation.

These levels are not written in stone, of course, but they come from a statistical normalization procedure. As a consequence, all four beacons pinpoint the CVI equivalent of the statistical standard deviations.

If you want to find an edge the CVI offers, you should look for violations of the 8 and ‑8 levels. So your focus here will be on over- and undervaluation signals. Going still farther from zero would result in far too few signals to build a meaningful sample space.