Monday, January 1, 2001

What is the Chicken Oscillator?

At it's heart, the Chicken Oscillator is a very simple price oscillator that measures a security's price momentum over time in order to identify potential entry and exit points.

The Chicken Oscillator consists of two simple components: a momentum line (blue) and a trigger line (white) that are plotted on a 100-point scale with 80 and 20 generally representing overbought and oversold readings, respectively.

The most basic trade signals are produced when the blue line crosses above the white line (bullish) or falls below (bearish).

Two expressions of the indicator - the Long Term Chicken Oscillator (LTCO) and the Short Term Chicken Oscillator (STCO) - are used simultaneously in order to identify both short-term and long-term trend changes. This gives the trader a unique sense of context, allowing him/her to identify and seize both long and short-term opportunities -- and even more importantly, to recognize the difference between the two.

The most basic trade signals are produced when the blue momentum line crosses the white trigger line.

Here's an example showing the LTCO over a ten year period of USD/JPY:

However, I have found the most reliable and most profitable signals are generated by a "backtest." A Chicken Oscillator backtest occurs when:

1) The blue momentum line crosses the white trigger line
2) The blue line then reverses course and attempts to re-cross the white line in the opposite direction but fails, resulting in a backtest
3) The blue line continues in the original direction and price moves swiftly in conjunction

Backtests are especially powerful when they occur in overbought/oversold territory.

Below are some examples that show the two variations of the backtest setup (Sharp and Meandering).

This chart of the S&P in 1987 shows a sharp backtest:

This chart of the Dow following the Great Depression shows a meandering backtest in 1933 (after the blue line crosses above the white line, it hovers there for a while but never breaks below) as well as a sharp backtest in 1937.

Backtests are my favorite set up because they usually produce very powerful and very profitable moves. They can also help you keep your cool if price unexpectedly moves against your position, as in this example of XLF on June 3:

And backtests can help you fade sudden price gaps, as in this example of XLF on May 20:

Aggressive traders should enter as close to the backtest as possible (for example, using intra-day readings to help time a daily backtest); more conservative traders may choose to wait until the backtest is confirmed by subsequent candlesticks or when the momentum line breaks out of a key level (e.g. 80 when overbought, 20 when oversold, and 50 when in mid-range).

Divergences Between STCO and LTCO

Because the LTCO and STCO measure different degrees of trend, divergences between the two oscillators are extremely useful in identifying when a short-term countertrend is about to end and the dominant primary trend is about to reassert its authority.

I have often referred to this as the "Bleed Off" set up. It occurs when:

1) The LTCO has clearly defined the long term trend ("long term" is relative to the time frame being examined)
2) The STCO begins moving in the opposite direction, alerting the trader that a short term countertrend is underway
3) Price remains somewhat flat or moves very little in conjunction with the STCO
4) When the STCO crosses over the short term countertrend has ended; a position is taken in the direction of the long term trend.

It's a really simple set up that's easy to jump on because it tends to provide plenty of advanced warning. Here are some examples:

This is the S&P from June 23.

This is the /ES from July 31.

Divergences Between Oscillator and Price

Oscillator Trend Lines

Trend Lines can be drawn on the oscillator as an additional aid in defining turning points. For example, the Dow respected a single trend line for almost all of the Great Bull. Monitoring this line would have assisted the trader in recognizing opportunities to buy the dips in 1991, 1994 and 1995. The breach in late 1998 was a clear warning that the 16-year trend was weakening.

Trend lines are especially useful following abnormally violent and/or prolonged price trends, such as the 2007-2009 decline. When a price move is so steep that the blue and white lines are at opposite ends of the spectrum, waiting for a crossover to occur before exiting can result in erosion of profit.

Also, if the blue momentum line is consistently turning without actually touching the white trigger line, the trader should look for a trend line that explains this behavior. Here's an example of IYR.

The Chicken Oscillator is also useful when it comes to confirming Elliott Wave counts. Each wave seems to have a unique signature on the oscillator. These signatures appear to be present at all degrees throughout the fractal Elliott Wave. In general:

1 is a breach (blue crosses white)
2 is a backtest (blue bounces off white)
3 gets pinned (in oversold/overbought territory)
4 is a false break
5 reverses the false break

A is a breach
B is a backtest
C is an exaggerated spike

Additionally, symmetrical triangles often produce distinct divergences between price and the oscillator - an important tell when trying to discern wave structure as it unfolds in real time (see "Divergences between Oscillator and Price" example above).

Here's a recent intra-day example of $BKX:

Capital Allocation - A simple way to benefit from signals on both oscillators is to allocate a portion of trading capital for both long term and short term trades. For example, a trader might use a 2:1 split, with two-thirds of capital deployed based on the signals of the LTCO, while one-third is reserved for exploiting STCO signals (e.g. hedging during countertrends and "juicing" when the short-term countertrend ends). This strategy can be used for the allocation of an entire portfolio as well as individual trades.

Stop Placement - It is strongly encouraged that stops be employed when trading with the Chicken Oscillator (or with any other system for that matter). Fortunately the Chicken Oscillator can help identify good points for stop placement.

1) A trade is entered based on an LTCO signal. A stop is immediately placed at the trader's discretion.
2) As the tape moves in the trader's favor, the trader watches for a countertrend to develop on the STCO. After the STCO crosses over signaling the end of the countertrend, the trader adjusts the stop to the highest/lowest point that corresponds with the peak/valley on the STCO.
3) This process continues until the trader is stopped out
4) If the trader is stopped out early and wishes to re-enter the trade, he is often free to do so based on the signal of the STCO -- because this stop placement strategy essentially employs the Bleed Off set up (see above), which is an acceptable entry signal!

Here's a recent intra-day example of General Electric:

The Chicken Oscillator has been backtested extensively against decades worth of daily, weekly and monthly data, as well as on an intra-day basis on this blog for the past several months. You may read about some of the trades I placed with the Chicken Oscillator during its testing period - good trades, bad trades and ones that got away - by clicking here.

Here are the results of two backtests of XLF.

Test #1
Period: January 1, 2003 to August 14, 2008
Chart Type: Daily
Prices: Prices listed are closing prices on the day the trade was taken.
Signal Types: All trades were based solely on conservative LTCO signals which are issued in a three step process:
1) The momentum line crosses the trigger line;
2) The momentum line successfully completes a backtest of the trigger line;
3) The momentum line breaks through a significant level (80 if overbought; 20 if oversold; 50 if the crossover occurred in mid-range). I have also included a few charts that illustrate the results of employing some of the optional techniques described above.

7/15/09Long$12.26$1.98 *16.15% *

*As of 8/14/09

In addition to the trade data, you may also view this chart so that you may judge for yourself the clarity and accuracy of each signal. Additionally, the yellow arrows illustrate the optional STCO stop placement system.

It should be noted that these results are based on the most rudimentary use of the system. These results are the kind that could be achieved if it were employed by a mindless, automated trading bot. If one simple trend line is also employed, the trader could have substantially improved results by obtaining a better exit price in early April 2009 (in the approx. range of $9.50). The chart below depicts this scenario.



9-11 chart