Disparity Index

Developed by Steve Nison and introduced in his book ”Beyond Candlesticks”, the Disparity Index measures the relative position of the most recent closing price of a trading instrument to a particular moving average and shows the resulting value as a percentage. It can be calculated as follows:

Disparity Index = (current market price – n-period moving average value) / n-period moving average value x 100.

In case the index shows 0, this indicates that the current price of the instrument equals the value of the n-period moving average.

In case the index shows a result below 0, this means that the current price of the instrument is below the value of the n-period moving average by that amount (percentage).

In case the index shows a result above 0, this means that the current price of the instrument is above the value of the n-period moving average by that amount (percentage).

The Disparity Index can generate several types of trading signals:

First, crossings over the zero line. In case the indicator crosses above its zero line, a signal to buy is generated. In case the indicator crosses below its zero line, a signal to sell is generated.

Second, searching for divergences between the price and the Disparity Index in order to identify a potential trend reversal or trend continuation setup. There are two types of divergences – regular and hidden. Regular divergences signal trend reversals, while hidden divergences signal trend continuation.

A regular bullish divergence is a situation, when the market forms lower lows, while the indicator forms higher lows.

A regular bearish divergence is a situation, when the market forms higher highs, while the indicator forms lower highs.

A hidden bullish divergence is a situation, when the market forms higher lows, while the indicator forms lower lows.

A hidden bearish divergence is a situation, when the market forms lower highs, while the indicator forms higher highs.

Third, taking advantage of overbought and oversold conditions. An overbought condition occurs, when the Disparity Index is at or above its upper bound. An oversold condition occurs, when the Disparity Index is at or below its lower bound. The upper and the lower bounds need to be carefully determined, after examining the sensitivity of the index to the instruments price movement, that it is being used to evaluate.

Chart Source: VT Trader