Hello,
I am posting here an extract from Dr. Alexander Elder's book Come Into My Trading Room.
Elders Thermometer
Market thermometer helps differentiate between sleepy, quiet periods and hot episodes when market crowds become excited. It can help one to adapt trading to the current environment.
Quiet markets typically have narrow bars that tend to overlap one another. Hot, boiling markets tend to have wide bars whose highs and lows extend far outside the previous days range. Beginners jump into trades during those wide bars, afraid to miss a runaway move. If one enters when the markets are quiet, the slippage is likely to be lower. Hot markets are good for taking profits because then slippage may work in your favor.
Market Thermometer measures how far the most extreme point of today, either high or low, protrudes outside of yesterdays range. The greater the extension of todays bar outside of yesterdays the higher the market temperature.
The formula of Market Thermometer,
Temperature = the greater of either (High today - High yesterday) or (Low yesterday - Low today)
Market temperature is always a positive number, reflecting the absolute
Value of either the upward or the downward extension of yesterdays
Range, whichever is greater. Plot temperature as a histogram
Above zero. Calculate a moving average of market temperature, and
Plot it as a line on the same chart. When markets are quiet, the adjacent bars tend to overlap. The consensus of value is well established, and the crowd does little buying or selling outside of yesterdays range. When highs and lows exceed
their previous days values, they do so only by small margins. Market
Thermometer falls and its EMA slants down, indicating a sleepy market.
When a market begins to run, either up or down, its daily bars start
pushing outside of the previous ranges. The histogram of Market Thermometer
grows taller and crosses above its EMA, which soon turns up,
confirming the new trend.
Market Thermometer gives four trading signals, based on the relationship between its histogram and its moving average :
1. The best time to enter new positions is when Market Thermometer
falls below its moving average.When Market Thermometer falls below its EMA, it indicates that the market is quiet.
2. Exit positions when Market Thermometer rises to triple the height of its moving average.
3. Get ready for an explosive move if the Thermometer stays below its moving average for five to seven trading days.
4. If you are a short-term trader and are long, add the value of todays Thermometer EMA to yesterdays high and place a sell order there. If you are short, subtract the value of the Thermometers EMA from yesterdays low and place an order to cover at that level.
Regards
Roneeth