Fisher Transform – Strategy, Rules, Returns
Traders are always seeking better ways to analyze the ever-changing price data in the financial markets, and one indicator that can transform the way you look at price data is the Fisher Transform. What do you know about this indicator?
Fisher Transform is a technical analysis indicator that converts the data from price movements into a Gaussian probability distribution, also known as normal distribution. This normalization of price data series makes it easier for traders to identify extreme price data, which could be potential turning points. The indicator may help in identifying potential turning points, as well as price trends.
In this post, we will take a look at the details of the Fisher Transform: what the indicator is about and how to calculate it, interpret it, and use it in trading. Let’s dive in!
Key takeaways
- The Fisher Transform is a technical analysis indicator that converts price movement data into a Gaussian, or normal, probability distribution.
- Normalization makes it easier to identify extreme price data.
- We show you an example of a backtested Fisher Transform trading strategy complete with trading rules and settings.
- Related reading:Â Best technical indicators for trading
What is the Fisher Transform in trading?
Fisher Transform is a technical analysis indicator that converts the data from price movements into a Gaussian probability distribution, also known as normal distribution. This normalization of price data series makes it easier for traders to identify extreme price data, which could be potential turning points. The indicator was created by John F. Ehlers to help in identifying potential turning points, as well as price trends. It is an oscillator, moving above and below the zero line.
When attached to the chart, the indicator appears in a separate window below the price, just like other oscillators like the MACD and Stochastic Oscillator. It has two lines that move up and down. The main indicator line is known as Fisher while the signal line is known as the Trigger. The indicator’s signals traders watch for include extreme readings, signal line crossovers, and divergences. These help them to identify potential reversal points where new trends are forming.
How does the Fisher Transform indicator work?
The Fisher Transform indicator works by using the natural log function to transform data, such as asset prices, which aren’t typically normally distributed into a Gaussian normal distribution. This data conversion helps traders and analysts to more accurately identify extreme price movements and potential reversals.
Basically, the conversion makes extreme price swings relatively rare — more like outliers in the normal distribution — which makes them easy to identify as potential price reversal points on a chart. Not only does it show potential trend reversals, but most especially, it shows the reversals of pullbacks for trend continuation.
Below is an example of what the indicator looks like on a chart:
What is the mathematical formula for the Fisher Transform?
The mathematical formula for the Fisher Transform is given as follows:
Fisher Transform = 0.5 * ln [(1 + X) / (1 – X)]
Where:
In = the natural logarithm function
X = the input data, which can be the price of any financial asset, such as the closing price of a stock or the exchange rate of a currency pair
The Fisher Transform calculated above gives the main indicator line. To obtain the signal line (Trigger), the formula is as follows:
Signal line = n-period moving average of Fisher Transform.
Fisher Transform trading strategy – trading rules, returns, performance
It’s time to put the indicator to the test. To do that, we make trading rules and backtest them.
We make the following trading rules:
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These three simple trading rules have returned the following equity curve for the S&P 500 (SPY) from its inception until today:
Let’s look at the statistics and trading performance metrics:
Table of Key Statistics (Fisher Transform)
| Statistics/Metrics/Key Data/Performance | Value |
|---|---|
| Number of trades | 98 |
| Average gain per trade | 1% |
| CAGR (Compound Annual Growth Rate) | 3.2% |
| Win rate | 76% |
| Average winning trade | 1.7% |
| Average losing trade | -1.4% |
| Max drawdown | -7% |
| Time invested in the market | 8% |
| Risk-adjusted return (CAGR divided by the time spent in the market) | 40% |
Is the strategy overfitted?
When we optimized the strategy, the sweet spot seemed to be a relatively short lookback period between 5 and 10 days. However, remember that the best settings vary from asset to asset.
Moving Average Envelope – complete code
Here’s the complete code for the strategy:
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We also backtested the same trading rules on Bitcoin, and we got the following equity curve:
There were only 42 trades, with an average of 3.55 per trade.
Why is the Fisher Transform used by traders?
The Fisher transform is used by traders because it normalizes the price data of an asset, which isn’t typically normally distributed. This price data transformation makes extreme price swings relatively rare — more like outliers in a normal distribution — thereby making them easy to identify as potential price reversal points on a chart.
It helps traders to more accurately identify extreme price movements and potential reversal points. With this information, traders can create better strategies and know when to enter or exit the market, as well as when to stay on the sidelines.
How can Fisher Transform help predict market turns?
Fisher Transform helps predict market turns by converting the data series of price movements into a normal distribution series, which easily shows extreme price swings as outliers. In doing so, it makes those extreme price swings stand out as potential price reversal regions.
In the indicator window, the signals appear as extreme readings in the oscillator, signal line crossovers, or divergences from the price action. These signals can help traders predict market turns, which could be the beginning of a new trend or the continuation of an existing trend after a prolonged pullback.
What are the best settings for the Fisher Transform?
The best settings for the Fisher Transform would depend on your trading style, trading timeframe, and ultimately, your backtesting result. Your trading style would determine the periods you set for the moving average smoothening of the Fisher Transform to form the signal line and also determine the timeframe you do your analysis and trading on.
If you are a day trader, you may want to trade on the lower timeframes, such as the hourly, 30-minute, or 15-minute timeframe. But if you’re a swing trader, you may want to use the 4-hourly timeframe or the daily timeframe. These timeframes determine how often the indicator produces a signal. However, the only way to know the best setting for the asset you are trading is by backtesting your strategy with different settings to know the one that offers the best performance.
How do I add the Fisher Transform to my trading chart?
How you add the Fisher Transform to your trading chart depends on the trading platform you’re using and whether it has a built-in Fisher Transform indicator — if it doesn’t have one, you need to get the indicator and install it in the platform first.
Once you have the indicator in the platform, go to the indicator section of the platform and search for Fisher Transform. Double-click on it or grab it and drag it to the chart. Put in your preferred settings — the default period is 9 periods, but you can change to what works best for you.
What are common signals from the Fisher Transform?
The common signals from the Fisher Transform indicator are as follows:
- Extreme readings: Traders consider extreme values as overbought/oversold conditions in the market. So, extreme positive reading indicates overbought conditions and potential downward reversal, while extreme negative readings indicate oversold conditions and potential upward reversal.
- Signal line crossovers: Traders also watch for signal line crossovers, especially at extreme levels. A downward crossover at the extreme positive end signals a potential downward reversal, while an upward crossover at the extreme negative end signals a potential upward reversal.
- Divergences from the price action: When the indicator divergence from the price swings, it could signal a potential reversal.
How does the Fisher Transform compare to RSI or MACD?
The Fisher Transform compares favorably to the RSI or MACD. All three are momentum oscillators that show potential price turning points. However, the Fisher Transform is unique in that it tries to convert the price data to a normal distribution and uses the outliers (extreme readings) to find potential reversal points. This is unlike the MACD, which uses the difference between short-period and long-period EMAs to estimate market momentum, or the RSI, which uses the ratio of the up periods to the down period to calculate market momentum.
Can Fisher Transform be used for all trading instruments?
Yes, Fisher Transform can be used for trading all trading instruments, including stocks, bonds, currencies, and commodities, since it is calculated based on price data, which can be easily obtained for any instrument. If it were a volume-based indicator, it would be difficult to use it in the spot forex market, as there is no central exchange to obtain reliable volume data.
However, since the Fisher Transform is only price-based, the data can be obtained and the indicator calculated for any market, including the spot forex market.
What time frames work best with the Fisher Transform?
The time frames that work best with the Fisher Transform depend on your trading style. If you are a day trader, you may want to trade on the lower timeframes, such as the hourly, 30-minute, or 15-minute timeframe.
But if you’re a swing trader, you may want to use the 4-hourly timeframe or the daily timeframe. For any trading style, the only way to know the best time frames for the instruments you are trading is by backtesting your strategy on different time frames to know the one that offers the best performance.
How reliable are Fisher Transform signals?
Fisher Transform signals are not always reliable when used alone, but you can improve their accuracy by combining them with other indicators or price action analysis. Any of the signal types — extreme readings, signal line crossovers, or divergences — can be used along with trend indicators or price action analysis to find trading opportunities.
For example, if you use a moving average to identify a major trend, you can use the Fisher transform to know when a major pullback is over and the price reversing to continue the trend.
What are typical false signals from the Fisher Transform?
Typical false signals from the Fisher Transform can be in these forms:
- Inconsistent extreme levels: It is difficult to determine what qualifies as an extreme reading, as the levels tend to vary over time even for the same instrument. So, the level you’re using may start giving false signals.
- Late signals: The indicator can lag the price by a lot, thereby producing late signals. It is not uncommon for the price to have turned and moved before the indicator signals a potential price turn.
- Whipsaws: If the market is highly volatile and spiking around, the indicator’s signal crossover signals will be whipsawed a lot, producing many false signals.
How do I interpret rapid changes in the Fisher Transform values?
To interpret rapid changes in the Fisher Transform values, you have to check the market condition. When the market is highly volatile, with the price spiking around, the indicator values can experience rapid changes. In that situation, your interpretation should be that the market is not good to trade — it is best to stay on the sidelines. This way, the indicator helps you to avoid being in the market when you shouldn’t.
What trading strategies incorporate the Fisher Transform?
Trading strategies that can incorporate the Fisher Transform include:
- Trend-continuation swing trades: These are swing trades that aim to profit from an impulse wave in the trend direction after a pullback. The Fisher Transform indicator can be used here to identify when the pullback is about to reverse for the trend to continue.
- Mean-reversion strategies: These are strategies that try to profit from the tendency of the price to revert to its mean after deviating significantly from it. They thrive on reversals from extreme levels, which the Fisher Transform can indicate when used properly.
How do I adjust the Fisher Transform for volatile markets?
To adjust the Fisher transform for volatile markets, you can increase the number of periods for the moving average so that it smoothens the indicator. This way, there will be less crisscrossing of the signal line. Another thing you can do is to use a higher time frame.
This can reduce market noise, which is usually too much in lower time frames. To know the best timeframe to use and the number of periods to set the indicator, you will have to do some backtesting and evaluation.
What are the risks of relying solely on the Fisher Transform?
The risks of relying solely on the Fisher Transform are many. These are some of them:
- False signals: The indicator can give lots of false signals if used alone as a trading strategy on its own. This is why it is not advisable to use it as a standalone indicator.
- Trading against the trend: If used without a trend indicator or price action analysis to first identify the trend, you run the risk of trading signals that appear against the trend direction.
How do I combine the Fisher Transform with other indicators?
To combine the Fisher Transform with other indicators, you have to first understand how the indicator works so as to know other indicators or technical analysis tools that can complement it.
Experienced traders use the Fisher Transform indicator in combination with other analysis tools, such as moving averages, trend lines, and support and resistance levels. this can help optimize the signals and reduce the number of false signals. Most importantly, it prevents you from trading against the main trend direction.
What does a negative Fisher Transform value indicate?
A negative Fisher Transform value indicates that the price action has been mainly bearish. The more negative the value, the more extreme the bearishness. Generally, -1 or -1.5 is taken as part of the normal bearish distribution of price action. When the value gets beyond -1.5 and starts falling further to -2 and beyond, there is likely an extreme bearish price swing — depending on the market, the level may be extreme enough to expect an upward reversal, especially if the major trend has been an uptrend.
What does a positive Fisher Transform value suggest?
A positive Fisher Transform value suggests that the price action has been mainly bullish. The more positive the value, the more extreme the bullishness. Generally, +1 or +1.5 is considered part of the normal distribution of bullish price action.
When the value gets beyond +1.5 and keeps rising further to +2 and beyond, there is likely an extreme bullish price swing at play — depending on the market, the level may be extreme enough to expect a bearish reversal, especially if the major trend has been a downtrend.
How to trade using Fisher Transform in a ranging market?
To trade using Fisher Transform in a ranging market, you have to first identify the boundaries of the price range. The upper boundary is the resistance level, while the lower boundary is the support level. When the price is at the resistance level, you look for a downward reversal signal on the Fisher Transform — a downward signal line crossover at an extreme positive level.
Likewise, when the price is at the support level, you look for a bullish reversal signal on the Fisher Transform — a bullish signal line crossover at an extreme negative level.
What are examples of successful trades using the Fisher Transform?
These are examples of successful trades using the Fisher Transform:
Example 1: US100 buy signal
In the US100 chart below, you can see that the price was trending upward, as indicated by the white uptrend line. The price reversed after bouncing off the trendline and creating a bullish divergence in the Fisher Transform. Both the price hitting an ascending support line (the trendline) and the bullish divergence in the indicator are confluence factors that make the bullish signal a strong one.
Example 2: US100 sell signal
In the same US100 chart below, you can see a downtrend. The price reversed after rallying to the downtrend line. Notice how the Fisher Transform showed a downward signal line crossover at close to +3 level. That’s a bearish signal at an extreme level, which makes it a strong signal.
How does Fisher Transform handle sharp price movements?
Fisher Transform handles sharp price movements by transforming them to normal distribution such that those extreme movements stand out as outliers to the normal distribution.
This way, they can be easily identified as abnormal price actions that could lead to a reversal. If such sharp price movements are bearish, they will show as extreme negative values in the indicator. On the other hand, if they are bullish, they will show as extreme positive values on the indicator.
What improvements can be made to the Fisher Transform?
The improvements that can be made to the Fisher Transform is to add a dynamic method of knowing what qualifies as an extreme level of the indicator for an instrument at any market condition. This shouldn’t be left for guesswork.
Meanwhile, traders who want to eliminate guesswork can always backtest and forward-test the markets to know the appropriate levels. Another way to improve the indicator is to use it with other indicators to create a robust trading strategy that can offer reliable signals.
Where can I learn more about the Fisher Transform?
Where you can learn more about the Fisher Transform indicator includes this page you are reading and other trading websites like therobustraders.com and tradingstrategies.com.
Another place you can learn about the indicator is on your trading platform — open it and practice a lot with the indicator, and you will learn more than all the resources on the internet can teach you.