One of the easiest ways to identify cyclical shifts in the stocks is using the Detrended Price Oscillator (DPO). This is used for identifying the cycle length, as well as the overbought or oversold condition. Let’s learn more about this indicator.
What is Detrended Price Oscillator?
The Detrended Price Oscillator oscillates around the zero level. This lagging indicator basically eliminates trends in prices. This is done by comparing the closing price to a prior moving average and eliminating all cycles that are longer than the moving average. As the long-term trends are eliminated, it helps to easily identify the cycles.
For example, if the value for DPO is set as 20-period, it means that it will remove cycles longer than 20 days. The figure below shows a DPO indicator.
One of the simplest signals by DPO is from the peaks and troughs formed by it.
- Uptrend: When the Detrended Price Oscillator makes a higher trough, it points to an upturn in the short to medium term cycle.
- Downtrend: When the Detrended Price Oscillator makes a lower peak, it indicates a downturn in the short to medium term cycle.
In addition, the historical peaks and troughs can also help in identifying potential buy and sell levels. There would be peaks and troughs in prices occurring every n-number of trading days in the case of some stocks. So, traders try to buy or sell the stock based on this cycle.
Detrended Price Oscillator and Zero Line
The zero line is quite significant in the case of the Detrended Price Oscillator.
- Cross Above Zero: When the DPO crosses above zero after falling below zero line, it indicates bullishness.
- Cross Below Zero: When the DPO crosses below zero after rising above zero line, it indicates bearishness.
How Traders Use Detrended Price Oscillator
Traders make use of DPO for picking long and short positions.
- When there is a strong uptrend, traders enter long positions when DPO dips below zero for a while and then goes up above zero; or hits zero from above.
- Traders enter long positions when there is a bullish divergence between DPO and price (DPO indicator makes higher low while the price at the same time makes a lower low).
- Traders go long when the DPO first cross below the oversold level and then get back above the oversold level.
- Traders go long when the stock reaches the turning points that align with the cyclical trough.
- When there is a strong downtrend, traders enter short positions when DPO crosses above zero for a while and then goes below zero; or hits zero from below.
- Traders enter short positions when there is a bearish divergence between DPO and price (DPO indicator makes lower high while the price at the same time makes a higher high).
- Traders go short when the DPO first cross above the overbought level and then get back below the overbought level.
- Traders go short when the stock reaches the turning points that align with the cyclical peak.
The figure below shows how traders use the cyclical highs and lows of DPO indicator for making better trades.