Alternative Chart Applications: Understanding the Hurst Exponent

[RichardCox 10]

Alternative Chart Applications: Understanding the Hurst Exponent

 

As traders move into the more advanced sections of their technical analysis education, it becomes important to start to look at some alternative indicators and oscillators that can be used to help you get an edge on the rest of the market. One example of a chart application that has been getting more attention in recent years is the Hurst Exponent, which is now used as a way of calculating market predictability and likely outcomes in price activity. Perhaps most interesting is the fact that these calculations were originally made for areas that are completely unrelated to price activity in the financial markets. In its earliest studies, the Hurst Exponent was used in hydrology to assess appropriate dam levels near the Nile river, and protect against the volatile rain and drought seasons that are historically prevalent in the region.

 

So, the main question is this: Can mathematical studies that have proven useful in unrelated areas of science actually be applied to technical price analysis? Some traders would argue that it makes no sense to use tools that were not developed specifically for the financial markets. After all, there is real money at risk and the use of unrelated tools could make trading outcomes unpredictable. Proponents, however, would argue that the financial markets are simply a small part of a much larger universe and that mathematical rules that hold true in one area will remain constant in others. And since the Hurst Exponent can be used as a chart plugin and be calculated using available market data, it makes sense to take a look at its relative elements that can be used and applied to forex trading.

 

The Hurst Exponent Defined

 

In relevant equations, the Hurst Exponent is typically denoted as H and gives us an understanding of the level of predictability in price behavior. The exponent fluctuates between values of 0 and 1. Values below 0.5 indicate “anti-persistence” in the time series, which essentially means that a bullish price movement is likely to be followed by bearish price movement (and vice-versa). Hurst values of 0.5 suggest markets will be characterized by Brownian motion, which essentially implies random price movements. Hurst values above 0.5 indicate “persistence,” which is a suggestion that market trends that are currently in place are likely to continue. All of this information can be used to identify the potential for markets to show “persistence” in trending activity, as it gives us an understanding of the level of predictability that is currently in place. The first graphic example shows the Hurst Exponent live in MetaTrader. In this instance, the reading shows activity at the 0.5 midpoint which indicates market predictability is at a minimum and trades should be avoided.

 

 

Trading Strategies

 

Once we understand how the Hurst Exponent reading can give us an idea of whether or not current market conditions are likely to continue, it should be understood that this information can prove highly valuable when we are looking to construct trades. Drilling down to the basics, buy positions could be established when the Hurst value is well above 0.5 and a bullish candle reforms on our charts. This Hurst reading would indicate “persistence” and increase the probabilities for success in buy positions. Bearish positions could be taken using the same indicator reading, but in this case we would need to see a bearish candle or clear evidence a downtrend is already in place. In cases where the Hurst reading is well below the 0.5 level, a condition of anti-persistence is in place and this lets traders know that current market conditions are likely to change. In this case, we would want to sell after bullish candles or uptrends, and buy when we see bearish candles or downtrends.

 

To sum up, trades using the Hurst Exponent can be undertaken using the following steps:

 

• Plot the Hurst Exponent based on the market’s price activity
  
• Identify the reading’s position, relative to the important 0.5 “line in the sand”
  
• Find the market’s sentiment in the current price candle (bullish or bearish)
  
• Alternatively, current market conditions can be assessed using moving averages or trend readings
  
• Trade accordingly, given the directional rules listed above
  

 

Limitations in the Hurst Calculation

 

Skeptics of the Hurst Exponent application in the financial markets might cite the fact that there is no way to precisely calculate its value. Instead, all we can do is estimate the coefficient. At its core, the Hurst reading is a linear regression slope that is determined using a series of logarithmic data points (a larger number of data points will generally give a better reading). Most of the available indicator plugins will use the previous 1,000 bars as the primary data set for the indicator reading. Skeptics might note that the usage of 1,000 bars might mean that your latest reading might not be an accurate assessment of the current market situation. Another point to remember is that the Hurst value is constantly fluctuating, and this might lead traders to exit positions prematurely.

 

Of course, the 1,000 data bars will not need to be kept constant. Fortunately, for those looking for variations even within the indicator itself, there are many plugins for MetaTrader that take care of these calculations for you. There are many different choices available on the internet (some are fee-based, others are free). One place a free download for the MT4 plugin can be found is here. So, as long as you understand the basic rules for interpreting applying the signals sent by the Hurst Exponent, it is entirely possible to start using the reading as a tool for confirming/rejecting your trading ideas.

 

Conclusion: The Hurst Exponent is a Valuable Tool for Confirming Trade Positions

 

Once we start to enter into the “advanced” stage of our trading education, it become important to start looking beyond the basic indicators (such as the MACD, RSI, of Stochastics) that are commonly used by a majority of the market. The Hurst Exponent is most useful as a confirming tool, as it gives you a sense of the level of predictability currently present in the market. If you are looking for a currency pair to buy, you will want to locate something with clear bullish momentum (using candlestick patterns, proximity to moving averages, or trend readings) and the highest possible H value (indicating market persistence). Bearish conditions would need to be in place for short positions, but you will still want a very high H value before committing. So, if you are typically using trend-following strategies, a Hurst exponent reading near the 1 level can prove to be a highly valuable confirming factor.

 

For contrarian traders, you will want to see Hurst readings in the opposite direction. A reading well below 0.5 suggests that market conditions are likely to reverse (anti-persistence). So if you identify a currency pairs that has seen a long term uptrend, it might be a good time to sell. Using the Hurst Exponent as a contrarian tool will also give you the added advantage of being able to buy low and sell high (something that is not possible with the higher H value readings). In addition to all this, it should be remembered Hurst Exponent readings near the 0.5 level suggest that market predictability is difficult (or impossible) to assess. In these cases, it makes sense to stance on the sidelines and look for higher probability opportunities.