Disparity Index – Strategy, Rules, Settings, Performance
There are many technical indicators and analysis tools traders can use to track how the market is moving, and one that is growing in popularity is the Disparity Index. What do you know about this indicator?
The Disparity Index is a momentum indicator that gauges the relative position of the most recent closing price to a chosen moving average. Its value is obtained by measuring the difference between the closing price and the moving average and reporting it as a percentage of the moving average. The indicator offers insights into market momentum and potential price reversals.
In this post, we will take a look at most of the questions you may have about this indicator: what it is, how it works, and how you can improve your trading strategies with it. Keep reading!
Key takeaways
- The Disparity Index is a momentum indicator that gauges the relative position of the most recent closing price to a chosen moving average.
- Its value is obtained by measuring the difference between the closing price and the moving average and reporting it as a percentage of the moving average.
- We make a backtested Disparity Index trading strategy with trading rules and settings.
- Please click here to read about all trading indicators.
What is the Disparity Index in trading?
The Disparity Index is a momentum indicator that gauges the relative position of the most recent closing price to a chosen moving average. Its value is obtained by measuring the difference between the closing price and the moving average and reporting it as a percentage of the moving average.
Introduced to the Western World by Steve Nison in his book Beyond Candlesticks, the indicator helps compare the current market price to a chosen-period moving average of the price. The indicator offers insights into market momentum and potential price reversals.
When the indicator rises above the zero line, it signals a positive momentum and the price is likely rising. Conversely, when the indicator falls below the zero line, the momentum is to the downside, and the price is likely falling. Extreme levels on either side imply that the price has moved significantly away from the moving average and may be due to reverse, at least a temporary pullback. The indicator may also show divergence from the price swings.
Disparity Index trading strategy – trading rules, settings, backtest, returns, and performance
The Disparity Index is mainly a mean reverting indicator, thus it should work very well in the stock market.
We make the following trading rules:
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CLICK HERE TO SEE ALL 350 ARTICLES WITH TRADING RULES
When we apply the trading rules on QQQ (Nasdaq 100), we get the following equity curve from its inception until today (slippage and commission of 0.03% per trade are included):
Trading performance metrics and statistics:
- Number of trades: 191
- Average gain per trade: 1%
- Annual returns: 7.3%
- Win rate: 77%
- Time spent in the market: 11%
- Risk-adjusted return: 65%
- Max drawdown: 19%
- Profit Factor: 2.6
The code of the strategy reads like this (Amibroker)
THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES
CLICK HERE TO SEE ALL 350 ARTICLES WITH TRADING RULES
How does the Disparity Index work?
The Disparity Index works as a momentum oscillator that measures the relative position of the current closing price to a chosen moving average. The indicator is plotted as an oscillator in the indicator window below the price chart. It oscillates around the zero line.
With its values oscillating above and below the zero line, which signifies the moment the current price is at the same level as the moving average, a value above zero shows that the current price is above the moving average, signifying that the market momentum is to the upside. On the other hand, a value below zero shows that the current price is below the moving average, signifying that the market momentum is to the downside.
While the indicator doesn’t have specified overbought and oversold levels, extreme levels on either side imply that the price has moved significantly away from the moving average and may be due to reverse, at least a temporary pullback. The indicator may also show divergence from the price swings. If the indicator is making a higher low when the price is making a lower low, there’s a bullish divergence, signaling a potential upward price reversal. Conversely, if the indicator is making a lower high when the price is making a higher high, there is a bearish divergence, which implies a potential downward price reversal.
Why is the Disparity Index important?
The Disparity Index is important because it shows how far the price is trading away from — above or below — the moving average, which can guide most types of traders in making trading decisions. It can tell momentum traders when the momentum is rising on either side so as to play their momentum game.
Similarly, it can inform contrarian traders (mean-reversion traders) when the price has moved significantly away from the moving average on either side so they can play their mean-reversion game. For most traders, whatever the trading approaches, the disparity index can be a helpful addition to their trading arsenal.
How to calculate the Disparity Index?
To calculate the Disparity Index, this is the formula to use:
Disparity Index = 100*(CCP — n-PMAV)/n-PMAV
Where:
CCP = Current Closing Price
nPMAV = n-Period Moving Average Value
These are the steps in calculating the Disparity Index:
- Choose the type of moving average — simple, exponential, or weighted.
- Select the period of the moving average.
- Obtain the current value of the moving average and the current closing price.
- Subtract the moving average value from the current closing price.
- Divide the difference by the moving average value.
- Multiply what you got by 100 to get the Disparity Index.
What is the formula for the Disparity Index?
The formula for the Disparity Index is given as follows:
Disparity Index = 100*(CCP — n-PMAV)/n-PMAV
Where:
CCP = Current Closing Price
nPMAV = n-Period Moving Average Value
How can beginners use the Disparity Index?
Beginners can use the Disparity Index by understanding how the indicator works and using it, alongside other indicators or analysis tools, to formulate specific trading strategies with clear entry and exit criteria plus risk management parameters. The strategies can be momentum based or mean-reversion based.
With momentum-based strategies, they aim to use the Disparity Index to identify price momentum and trade in that direction. So, they may choose to combine the index with long-period moving averages or trendlines to identify the main trend and look for rising momentum in that direction. Mean-reversion strategies, on the other hand, aim to identify when the price has moved significantly away from the moving average so as to trade a potential reversal to the mean.
What does a high Disparity Index indicate?
What a high Disparity Index indicates will depend on where the index lies relative to the zero centerline and how it is moving. If the index has just crossed above the zero line and keeps rising, it indicates that there is a rising price momentum to the upside — in other words, there is buying pressure. If the index is very far above the zero line — say, +2.5 or more, depending on the cutoff level you choose for the market under study — it could mean that the market is overbought and likely to reverse soon.
What does a low Disparity Index mean?
What a low Disparity Index indicates will depend on where the index lies below the zero centerline and how it is moving. If the index has just crossed below the zero line and keeps falling, it indicates that there is a rising price momentum to the downside — in other words, there is increasing selling pressure.
On the other hand, if the index is very far below the zero line — say, -2.5 or more, depending on the cutoff level you choose for the market you’re analyzing — it could mean that the market is oversold and likely to reverse soon.
How to interpret the Disparity Index?
To interpret the Disparity Index, you have to check where the index lies relative to the zero centerline, how it is moving, and whether there is a divergence from the price swings. If the index rises above the zero line and keeps rising, it indicates that there is a rising price momentum to the upside — in other words, there is buying pressure. On the flip side, if the index falls below the zero line and keeps falling, it indicates that there is a rising price momentum to the downside — in other words, there is increasing selling pressure.
Conversely, if the index is very far away from the zero line — say, beyond +2.5 or -2.5, depending on the cutoff level you choose for the market you’re trading — it could mean that the market is overbought or oversold, as the case may be, and hence, likely to reverse soon. The likelihood of a reversal is higher if the indicator swings diverge from the price swings.
What are the benefits of the Disparity Index?
The benefits of the Disparity Index include:
- It helps you to identify where the price momentum lies — the bulls’ side or the bears’ side.
- It can tell you whether there is buying or selling pressure in the market.
- It can be used to know when the current price is significantly away from the mean so as to anticipate market reversals or at least a temporary pullback.
- Its divergence signals may tell when the price is likely about to reverse.
- It can be combined with other indicators or analysis tools to create trading strategies.
What are the limitations of the Disparity Index?
The limitations of the Disparity Index include:
- Lagging: The Disparity Index can lag behind the price action especially when waiting for it to cross the zero line to confirm a change in price momentum, leading to late entries and exits.
- Poor signals: The index can produce too many false signals when used alone, especially in sideways or range-bound markets when it can crisscross the zero line a lot.
- No defined overbought/oversold levels: It has no defined overbought/oversold levels, so the trader has to define that for themselves.
- Not a standalone strategy: The indicator cannot be used alone as a trading strategy on its own — it must be combined with other analysis tools to get the best out of it.
How does the Disparity Index compare to other indicators?
Compared to other indicators, the Disparity Index is similar to the OsMA (Oscillatory Moving Average) in that it oscillates around the zero line, indicating the direction of price momentum. Also, its extreme levels could signal overbought/oversold market conditions, and its divergence from the price swings could signal a potential market reversal. The OsMA works in a similar fashion, except that it uses the difference between two moving averages, rather than the difference between the current price and a moving average.
What is the history of the Disparity Index?
The history of the Disparity Index is quite recent, at least in the Western World where it was introduced in 1994 by Steve Nison. Nison explained the indicator in his book titled: “Beyond Candlesticks: New Japanese Charting Techniques Revealed.” According to the book, the indicator has been in use in Japan for a long time to complement their candlestick analysis. Nison likened the index to dual moving averages, which had been in use among European and American traders before then.
Can the Disparity Index predict market trends?
Yes, the Disparity Index can predict market trends, at least, in the short term. When the indicator rises above the zero line and keeps rising, it means that the short-term market trend is up, and the price is likely rising. Conversely, when the indicator falls below the zero line and keeps declining, it means that the short-term market trend is downward, and the price is likely falling. However, this is up to a certain point on either side beyond which the indicator may signal a significant price deviation from the moving average and the possibility of a reversal or a temporary pullback.
How to combine the Disparity Index with other tools?
To combine the Disparity Index with other tools, such as other indicators or price action analysis, you have to first understand how the indicator works. That way, you will know the right tools that can complement it to bring the best out of it. When combining the index with other tools, the key is to use them to formulate a reliable trading strategy with clear entry and exit criteria. You will have to backtest the strategy to be sure it has a positive expectancy before deploying it.
What markets can use the Disparity Index?
The markets that can use the Disparity Index include all financial markets because it is calculated from the historical price data alone and all financial markets have price data. The story will be different if it uses volume in its calculations since certain financial markets, such as the spot forex, do not have reliable volume data because it is traded over the counter. As long as you can get the price chart or historical price data of any market, you can use the disparity index there.
How does the Disparity Index affect trading strategies?
The Disparity Index affects trading strategies by showing which side the market momentum lies and also when the market is likely to reverse. Thus, it can be used in momentum and mean-reversion trading strategies. In momentum trading strategies, the indicator can be used to spot when the price momentum is in the direction of the main trend so as to trade in that direction. For mean-reversion strategies, the index can show when the price has traded significantly away from the mean (moving average) so as to anticipate a reversal.
What are common mistakes using the Disparity Index?
The common mistakes when using the Disparity Index include:
- Not combining the indicator with other indicators or analysis tools to better understand the market structure and improve its signals
- Trading against the direction of the main trend, which often happens when using the indicator as a standalone trading strategy
- Not having a robust and backtested trading strategy
- Not having a risk management plan
How often should you check the Disparity Index?
How often you should check the Disparity Index will depend on your trading style, your trading timeframe, and the market you’re trading. If you are a day trader, you may be trading on the hourly, 30-minute, or 15-minute timeframe. Whatever timeframe you’re using, you may have to check the indicator at least once during the timeframe — usually at the close of the price bar. But if the market you’re trading is quite volatile, you may have to check the indicator more often than the trading timeframe.
What is a good Disparity Index value?
A good Disparity Index value depends on what you’re looking for in the market. If you are looking to spot a market with rising upside momentum, you may want to look for a Disparity Index Value that just rose above the zero level. On the other hand, if you are looking for a market that is ripe for a mean-reversion trade, you may want to look for an extreme value — probably higher than +2.5 if you choose that as your cutoff level for the market you’re trading.
How does market volatility affect the Disparity Index?
Market volatility affects the Disparity Index by causing it to give conflicting signals. When the market is highly volatile and spiking up and down, the Disparity Index will be crisscrossing the zero line, thereby giving two opposite signals within a short while. The indicator works best in markets with clear trends. This is why you have to combine the index with other indicators to know when the market condition is not suitable for its signals.
What software supports the Disparity Index?
All trading software supports the Disparity Index since it is a common indicator. However, the indicator may not come preinstalled in every trading software. You may have to get a custom-made Disparity Index for the trading software you are using and install it yourself. In some trading platforms, like TradingView, you can find some custom-made indicators when you search in the indicator section.
Can the Disparity Index be used in day trading?
Yes, the Disparity Index can be used in day trading if you use it on the right trading timeframe. The usual timeframe for day trading is the hourly, 30-minute, or 15-minute timeframe. Any of these timeframes can show you the intraday price moves you can use to spot trading opportunities. What matters is to create a reliable trading strategy with an edge so you can trade profitably. Don’t forget to backtest the strategy before putting your money on the line.
How to customize the Disparity Index settings?
To customize the Disparity Index settings, you have to know what you want to achieve with the new settings. Next, you create a strategy for that, with clear entry and exit criteria. You should also factor in your risk management plan. Then, you backtest your strategy with different settings to know the one that performs the best. That would be the settings you customize for your indicator.
What are real-world examples of the Disparity Index?
Here are some real-world examples of the Disparity Index:
Example 1: Amazon Chart, Buy Signal:
Look at the AMZN chart below. You can that the current upswing in the stock started with the Disparity Index rising above the zero level.
Example 2: Amazon Chart, Sell Signal
In the AMZN chart below, shortly after the market turned downward, the Disparity Index fell below the zero line, indicating a rise in downward price momentum.
