Definition and how to use it in trading

What is the Fisher transformation indicator?

The Fisher Transform Indicator is a technical indicator that transforms prices into a Gaussian normal distribution. It highlights when prices have moved to an extreme based on recent prices. This can help spot turning points in the price of an asset. It also helps to show the trend and isolate the price waves within a trend. The Fisher Transform Indicator was created by John F. Ehlers.

Formula and how to calculate the Fisher transformation indicator

Fisher Transform = 1 2 ∗ ln ⁡ ( 1 + X 1 − X ) where: ln ⁡ is the natural logarithm X = transformation of price to a level between -1 and 1 \begin{aligned} &\text{Fisher Transform} = \frac{1}{2}*\ln \left( \frac{1+X}{1-X} \right)\\ &\textbf{where:}\\ &\ln \text{ the natural logarithm is }\\ &X = \text{transformation of price to a level between -1 and 1}\\ \end{align}

,Fisher Transform=21,∗ln(1−X1+X,)where:ln is the natural logarithmX=transformation of price to a level between -1 and 1,

Now that you know the formula, you can use the following steps to calculate the Fisher Transform Indicator:

Select a lookback period. This is how many time periods you apply to the Fisher Transform Indicator. For example, you can select 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 close 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 previous calculated value.

Understanding ​​the Fisher Transform Indicator

As mentioned above, the Fisher Transform Indicator is an indicator used in technical analysis. It was developed by the 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 allows traders to create a Gaussian normal distribution. It transforms data that is not typically normally distributed, such as market prices. Essentially, 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 look for leading signals rather than lagging indicators. Using the Fisher Transform Indicator can help traders understand the movement of asset prices and market conditions.

How to apply the Fisher Transform indicator to trading

The Fisher Transform indicator is unbounded, which means that 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 fall (or has already started to fall) when the indicator goes lower after reaching an extremely high level with a strong price rise in the asset.

The Fisher Transform Indicator often has a signal line attached. It is a moving average (MA) of the value of the indicator, so it moves slightly slower than the Fisher Transform line. Some traders use it as a trading signal when the indicator crosses the trigger line. For example, when it drops below the signal line after hitting an extreme high, it can be used as a signal to sell a current long position.

As with many indicators, the Fisher Transform Indicator will provide many trading signals – many of which are not profitable to follow. Some traders prefer to use the indicator in conjunction with trend analysis. For example, when the price is rising, you can use it for buy and sell signals – not for short sell signals. During a downtrend, you can use it for short selling signals and ideas on when to cover.

The Fisher Transform Indicator vs Bollinger Bands®

These two indicators look very different on a chart, but both are based on a spread of asset prices.

Bollinger Bands® use a normal distribution in that they use standard deviation to show when the price may be overstretched. 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 laid over the price.

Limitations of the Fisher Transform Indicator

Although the Fisher Transform Indicator is a popular tool for technical analysts, there are certain disadvantages to using it. For example:

It can be quite noisy at times, even though it intends to make turning points easier to identify. Extreme readings are not always followed by a price reversal. Sometimes the price moves sideways or even reverses just a small amount. What qualifies as extreme can also be difficult to judge, as the levels tend to fluctuate over time. Four can be a high level for years, but readings of eight can start appearing regularly. Looking at all 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 movements may be short-lived. Asset prices are not normally distributed, so attempts to normalize prices may be inherently flawed and may not produce reliable signals.

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 spotting trends and identifying 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 in conjunction with others to provide a more accurate picture of the market so that the potential for loss is minimized.