Stocks & Commodities V. 4:8 (319-320): Detecting hidden signals by Clifford J. Sherry, Ph.D.

Detecting hidden signals

by Clifford J. Sherry, Ph.D.

D o you have a signal, such as a particular pattern of price movements, that is buried in noise like
random fluctuations or seasonal trends? If you believe this signal is time-locked to some internal event,
like a particular pattern of price changes, or an external event, like the beginning of a trading week or
month, you may be able to use a relatively powerful technique called averaging to detect your signal.
Averaging is done with a special-purpose computer and is used in such disciplines as neurophysiology or
electrical engineering to detect a signal buried in noise.
You can use this technique on raw prices, price changes, or categories of prices or price changes. For the
purpose of illustration, I will use categories of price changes as the data. The technique used to establish
the categories is described in the April 1986 issue of Stocks & Commodities ("Detecting a Dependent
Process").

Do you have a signal that is buried in noise like random

fluctuations or seasonal trends?
Briefly, you obtain the price categories as follows: 1) obtain price changes by subtracting price one from
price two, price two from price three, and so on; 2) collect the price data into a histogram; 3) divide the
histogram into parts, like thirds; 4) examine each sequential price change and determine in which third of
the histogram it belongs; 5) assign each price change a 1, 2, or 3 depending on which third of the
histogram it is in.
If you do this, you will have a long string of 1's, 2's, and 3's each associated with the date at which it
occurred. In this example, the data are the closing prices of soybean meal (4/11/80—4/30/81) where a 1
represents a price change from -10.00 to -1.20, a 2 represents a price change from -1.10 to + 1.80, and a 3
represents a price change from + 1.90 to +10.00 (see Figure 1).
You are now ready to construct your averaging histograms. You will need to construct a series of bins.
For example, if you want to use the beginning of the trading month as the trigger, you will need to label
the bins 1 to 31. If I am doing this using paper and pencil, I usually use yellow (lined) legal pads to
construct my bins and for my sequential list of 1's, 2's, and 3's. You can use the bins to represent trading
days, with or without weekends and holidays.
In the first example, as shown in Figure 2, I will use the trading days in a month so I will need only 23
bins. In order to construct my histogram, I will take my long series of 1's, 2's, and 3's and line up the first
trading day of the month with bin 1 (the leftmost bin). Then I record the 1's, 2's, and 3's that represent the
price change categories into the bins that are located immediately above them.
I then move the entire list of 1's, 2's, and 3's to the left, line up the first trading day of the next month with
bin 1, and enter my sequential list of 1's, 2's, and 3's immediately above those for the first month. Then, I
move the entire list to the left and line up the first day of the third trading month with bin 1, and so on. I
continue this process for each month for which I have data.

Article Text Copyright (c) Technical Analysis Inc. 1

Stocks & Commodities V. 4:8 (319-320): Detecting hidden signals by Clifford J. Sherry, Ph.D.

Figure 1: The method used to collect price change data used to construct the price change histogram.
The data is based on Soybean Meal closing prices, 4/1/80 through 4/30/81.

Figure 2: The first trading day of the month of April 1980 is lined up with Bin #1. Then the categories
are recorded into the "Month 1" line above the "Bins" line. Then the process is repeated with each
month thereafter until the data is exhausted.
Stocks & Commodities V. 4:8 (319-320): Detecting hidden signals by Clifford J. Sherry, Ph.D.

I can also do this while including weekends and holidays. In this case, I merely do not enter a value in the
bin that represents a non-trading day. The completed histogram, which includes trading and non-trading
days, is shown in Figure 3.

You can use this technique on raw prices, price changes, or

categories of prices or price changes.
To complete the averaging process, merely sum the values in each bin and divide the sum by the number
of entries in the bin. The more months you can average, the more accurate the average will be. The result
is the averaged price change category.
The averaged data for Figure 3 is shown in Figure 4. In this case, no discernible pattern shows for
monthly analysis of soybean prices, as expected. A good exercise, though, would be to run this analysis
using monthly data for each crop year. If seasonality exists in soybean prices, the pattern of the sectors of
price changes would show up in this histogram.
If you maintain a list of the sums in each bin, you can update your averaging histogram on a daily or
weekly basis, as you obtain new information. Hopefully, you can use the information obtained to make
wiser trading decisions.
Dr. Sherry is a neurobiologist and free lance writer with advanced degrees in psychology from the
Illinois Institute of Technology. He has spent most of the last 20 years trying to understand how the
nervous system processes information. He has developed a number of statistical techniques to deal with
complex time series. He is not an active trader, but continues to spend his time developing new methods
to detect a signal in noise.

Figures Copyright (c) Technical Analysis Inc. 2

Stocks & Commodities V. 4:8 (319-320): Detecting hidden signals by Clifford J. Sherry, Ph.D.

Figure 3: This is the complete allocation of the soybean price change sectors including weekends and
holidays. Excluding weekends and holidays would leave 23 days in the table and no spaces.

Figures Copyright (c) Technical Analysis Inc. 4

Stocks & Commodities V. 4:8 (319-320): Detecting hidden signals by Clifford J. Sherry, Ph.D.

Figure 4: The categories tabulated in Figure 3 are averaged for each bin. In this case, no discernible
pattern emerges for daily changes in soybean prices.

Figures Copyright (c) Technical Analysis Inc. 5