Fisher Transformation

The common perception is that all prices follow the standard bell-shaped curve known as the Normal or Gaussian Probability Density Function. This assumes that 68% of a range of samples will fall within one standard deviation around the mean. However, this perception has a fundamental flaw and could explain why a lot of trading indicators do not yield the results many would hope for. Lets assume that prices follow a square wave pattern and we adopt a trading system where we take a price that crosses a moving average. What we will find is that by the time any price movement has been detected, it has already switched to the opposite value. As with a square wave, the price has only two values, so there is be a clear 50% probability that the price will be only one of those values. So, despite any confusion around how to calculate a probability density, the concept is no more complicated than understanding how likely it is that a certain price will be achieved. Lets now compare a Gaussian, or Normal, Probability Density Function to that of a sine wave cycle. The first thing we notice is that with a sine wave, the majority of the data points will be present at the extremes of the sine wave cycle and more closely resemble that of a square wave. This therefore means that in terms of trading, unless you are able to predict the turning point of the cycle as per the method used in the Hilbert Sine Wave Indicator, the probability is that you are more likely to hit one of these extremes, which will make successful trading more difficult. So we can conclude that, as the Gaussian PDF will have the majority of values around the mean and the sine wave has the majority of its values at its extremes, the probability density function of a sine wave is not similar to that of the Gaussian probability density function. This brings us to the Fisher Transformation. The main concept of the Fisher Transform is that by applying it to a sine wave it alters the probability density function of a wave so that it more closely matches that of a Gaussian PDF. It does this by limiting any input values to within a range confined to no greater than 1 to +1. This means that input data that is close to the mean yields a parallel gain. However, input data at the extremes of the range yields exaggerated results mirroring the largest deviations away from the mean. The effects of the Fisher Transform can be significant in trading terms. As the Fisher Transform has standardised prices so that they remain within a -1 to +1 range, the exaggerated price movements become less common. In so doing, it becomes easier to identify those critical turning points. If we compare the Fisher Transform approach to the more traditional indicator represented by the Moving Average Convergence / Divergence, or MACD, we notice a difference. The MACD shows smoother, less obvious turning signals meaning one cannot be certain as to exactly when the cycle is starting or leaving a new phase. This will inevitably create delays when deciding when to buy or sell.

However, with the Fisher Transform, the cycle or price turning points are not only very clear and definite but they are immediate. This transparency and immediacy provides an obvious advantage for trading. So in effect, the Fisher Transformation can not only minimise the frequency of peak price swings and move it towards a more normal probability density function but it will also clearly and quickly identify when prices are turning in time to maximise trading performance.

http://iticsoftware.com /fisher-transform