What Is the Fisher Transform Indicator?
The Fisher Transform Indicator is a technical indicator that converts prices into a Gaussian normal distribution. It highlights when prices have moved to an extreme, based on recent prices. This may help in spotting turning points in the price of an asset. It also helps show the trend and isolate the price waves within a trend. The Fisher Transform Indicator was created by John F. Ehlers.
Key Takeaways
- The Fisher Transform Indicator is a technical indicator that normalizes asset prices, thus making turning points in price clearer.
- The indicator's formula is typically applied to price and can also be applied to other indicators.
- Some traders look for extreme readings to signal potential price reversal areas, while others watch for a change in the direction of the Fisher Transform Indictor.
- Asset prices are not normally distributed, so attempts to normalize prices via an indicator may not always provide reliable signals.
Formula and How to Calculate the Fisher Transform Indicator
FisherTransform=21∗ln(1−X1+X)where:lnisthenaturallogarithmX=transformationofpricetoalevelbetween-1and1
Now that you know the formula, you can use the following steps to calculate the Fisher Transform Indicator:
- Choose a lookback period. This is how many periods you apply to the Fisher Transform Indicator. For instance, you may choose nine periods.
- Convert the prices of these periods to values between -1 and +1 and input for X, completing the calculations within the brackets of the formula listed above.
- Multiply by the natural logarithm.
- Multiply the result by 0.5.
- Repeat the calculation as each near period ends, converting the most recent price to a value between -1 and +1 based on the most recent nine-period prices.
- Calculated values are added/subtracted from the prior calculated value.
Understanding the Fisher Transform Indicator
As noted above, the Fisher Transform Indicator is an indicator used in technical analysis. It was developed by author, trader, and engineer John F. Ehlers. Ehlers became a trader in the mid-1970s and created several indicators that are used by traders today.
The Fisher Transform Indicator enables traders to create a Gaussian normal distribution. It converts data that isn't typically normally distributed, such as market prices. In essence, the transformation makes peak swings relatively rare events to help better identify price reversals on a chart.
This technical indicator is commonly used by traders looking for changes and trends in asset prices. More specifically, they generally seek leading signals rather than lagging indicators. Using the Fisher Transform Indicator can help traders understand the movement of asset prices and market conditions.
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How to Apply the Fisher Transform Indicator to Trading
The Fisher Transform indicator is unbounded, which means extremes can occur for a long time. An extreme is based on an asset's historical readings. For some assets, a high reading may equal seven or eight, while a low reading may be -4. These values may differ for other assets.
An extreme reading indicates the possibility of a reversal. This should be confirmed when the indicator changes direction. For example, an asset price may drop (or has already started dropping) when the indicator heads lower after reaching an extremely high level with a strong price rise in the asset.
The Fisher Transform Indicator frequently has a signal line attached. This is a moving average (MA) of the indicator's value, so it moves slightly slower than the Fisher Transform line. Some traders use it as a trade signal when the indicator crosses the trigger line. For example, when it drops below the signal line after hitting an extreme high, it could be used as a signal to sell a current long position.
As with many indicators, the Fisher Transform Indicator will provide lots of trade signals—plenty of which are not profitable to follow. Some traders prefer to use the indicator in conjunction with trend analysis. For instance, when the price rises, you can use it for buy and sell signals—not for short-sell signals. During a downtrend, you can use it for short-sell signals and ideas on when to cover.
The Fisher Transform can also be applied to other technical indicators, such as the relative strength index (RSI) or moving average convergence/divergence (MACD).
The Fisher Transform Indicator vs. Bollinger Bands®
These two indicators look very different on a chart, yet both are based on a distribution of asset prices.
Bollinger Bands® use a normal distribution in that they use standard deviation to show when the price may be overextended. Fisher Transform, on the other hand, uses a Gaussian normal distribution.
The Fisher Transform appears as a separate indicator on a price chart, while Bollinger Bands® are overlayed over the price.
Limitations of the Fisher Transform Indicator
Although the Fisher Transform Indicator is a popular tool for technical analysts, there are certain drawbacks to using it. For instance:
- It can be rather noisy at times, even though it intends to make turning points easier to identify. Extreme readings aren't always followed by a price reversal. At times, the price moves sideways or even reverses only a small amount.
- What qualifies as extreme can also be hard to judge, since the levels tend to vary over time. Four may be a high level for years, but readings of eight may start to frequently appear.
- Looking at all of the changes in direction on the Fisher Transform Indicator can help spot short-term changes in price direction. However, the signal may come too late to capitalize, as many of these price moves may be short-lived.
- Asset prices are not normally distributed, therefore attempts to normalize prices could be inherently flawed and may not produce reliable signals.
What Is the Difference Between the Fisher Transform Indicator and the Moving Average Convergence/Divergence ?
The Fisher Transform Indicator and moving average convergence/divergence are two different indicators that are used in technical analysis. Both of these tools provide traders with valuable information about trend signals. The Fisher Transform Indicator normalizes asset prices by transforming them while the MACD depends on moving averages and can be used in trading strategies involving short-term trends. The Fisher Transform Indicator is generally considered to be more accurate because it provides a clearer picture of how the market is moving.
What Is Technical Analysis?
Technical analysis is a trading strategy or discipline that uses past performance and data to find opportunities in the market. Traders analyze asset prices, implied volatility, and trading volume to make predictions about future performance. This data is used in calculations of various technical indicators, then plotted on charts and graphs that can help the trader pinpoint entry and exit points.
What Is a Technical Indicator?
A technical indicator is a signal that traders use in technical analysis. It relies on key asset data—namely, historical prices and trading volume. They are commonly used to analyze short-term movements and are also useful for long-term traders who want to identify entry and exit points. There are thousands of technical indicators, which generally fall into two categories: overlays and oscillators. Examples include the Fisher Transform Indicator, moving averages, the relative strength index, and the moving average convergence/divergence.
The Bottom Line
Indicators help technical traders find opportunities in the market. The Fisher Transform Indicator is one of these tools. The indicator allows traders to create a Gaussian normal distribution by converting prices. Among the benefits is being able to spot trends and identify price waves within the trend. Traders should keep in mind that although it is considered a reliable tool, the Fisher Transform Indicator should be used with others to provide a more accurate picture of the market so the potential for loss is minimized.
