Detrended Price Oscillator: Meaning, Calculation and Interpretation

In this article, we will discuss

• What is the Detrended Price Oscillator?
• How the Detrended Price Oscillator Works
• DPO Formula and Calculation
• Interpreting DPO Values
• The DPO on a Chart: Graphical Representation and Interpretation
• Conclusion

Technical analysis can be incredibly helpful for short-term trading. Various trading indicators like the RSI, MACD and moving averages help you identify the direction and the momentum of a price trend. However, what if you need to find the next possible price peak or trough, irrespective of the overall trend?

If that’s what you are interested in, the detrended price oscillator (DPO) may be just the indicator you need to analyse. In this article, we explore the meaning of the DPO indicator, how it is calculated and how you can interpret it to make new trades or close existing positions.

What is the Detrended Price Oscillator?

The detrended price oscillator is a technical analysis indicator that filters out trend-related noise, so you can focus on the underlying short-term price cycles. By studying the DPO, you can obtain more clarity about the distance (or the duration) between two price peaks and troughs.

In other words, this trading indicator tells you how much time elapsed between the highest price point and the next lowest price point, or between two successive price lows or highs. This data is useful if you want to understand when the market is oversold and due for a price rise or is overbought and due for a price fall.

How the Detrended Price Oscillator Works

In the DPO, the time or the cycle of price changes matters more than the trend. Hence, the name ‘detrended’ oscillator. Instead of measuring price oscillations across various broader or long-term trends, the DPO focuses on oscillations between peaks and troughs — and the time taken for such oscillations. It does not give much weight to price trends or momentum. Instead, it tells you about the nuances of historical price cycles, so you can plan your trades using those timelines as a benchmark.

The DPO essentially works by comparing a particular past price with the stock or security’s simple moving average (SMA) over a specific period. This also means that the detrended price oscillator is a lagging indicator. It uses historical data, which forms the foundation of your trading decisions. Past price cycles are extrapolated to anticipate future price peaks and dips.

DPO Formula and Calculation

The DPO compares the past price of a stock or security with its simple moving average. To calculate the DPO, you need to use this formula.

Detrended Price Oscillator = Closing price from (n/2 + 1) periods ago — SMA for ‘n’ periods

Here, ‘n’ refers to the number of trading sessions that make up the lookback period. Typically, 20 to 30 sessions are considered to calculate the DPO. Let us break down the steps involved in calculating the DPO:

• Step 1: Identify the number of periods you want to consider.

• Step 2: Determine the closing price of the asset at the end of the (n/2 + 1)th period. For instance, if you are considering 30 periods, you need to find the closing price from 16 periods ago.

• Step 3: Find the simple moving average for the ‘n’ periods being considered.

• Step 4: Subtract the SMA from the closing price determined in Step 2. This is the DPO.

Let us discuss an example for more clarity. Say you are considering 22 trading sessions, with the following closing price and SMA data.

• Price from 12 periods ago (i.e. 22/2 + 1): Rs. 500
• 22-day SMA: Rs. 480

This gives us a DPO of Rs. 20 (i.e. Rs. 500 — Rs. 480).

Interpreting DPO Values

Once you know how to calculate the value of this trading indicator, you need to understand how to interpret the values you obtain. Essentially, the value of the indicator can be positive or negative. Its magnitude also matters. Here is how you can interpret the DPO values in different cases.

• Positive DPO Values: If the DPO is positive, it means the price near the middle of the lookback period is above the SMA. This suggests a short-term upward price movement relative to the long-term trend.

• Negative DPO Values: If the DPO is negative, it means the price near the middle of the lookback period is below the SMA. This suggests a short-term downward price movement relative to the long-term trend.

• The Magnitude of DPO Values: The larger the magnitude of the DPO value, the more significant the short-term price movement is.

• Zero DPO: If the DPO is zero, it indicates that the short-term and long-term price movements are nearly aligned.

The DPO on a Chart: Graphical Representation and Interpretation

Numerical interpretation is only one part of the story. The detrended oscillator is often represented graphically using a line graph or a histogram below the price chart. Let us study the key elements of this type of chart, so you can understand how to use the DPO in your trading decisions.

• The Zero Line: The zero line is a horizontal line drawn at the centre of the DPO chart. It represents the point where the past price equals the DPO.

• Oscillations: The DPO oscillates above and below the zero line and forms peaks and troughs. The areas above the zero line are typically highlighted in green, while those below are shown in red.

• Vertical Lines: Vertical lines, which are drawn at peaks and troughs on the DPO chart, help you visualise price cycles more easily. The distance between two successive peak lines or trough lines represents the duration of one complete price cycle.

Now that you know how a DPO chart is designed, here is how you can interpret what you see on the chart.

• Crossing the Zero Line: When the DPO cuts the zero line from below and moves upward, it may indicate a potential short-term bullish price movement. Similarly, a DPO crossing from above the zero line to below it may indicate a possible short-term bearish phase.

• Identifying Price Cycles: The distance between one peak and the next (or one trough and the next) helps you identify the length of price cycles. This can be useful in anticipating potential price reversal points.

• Divergences: You can also look for any divergence between the DPO and the price of the stock or security. If the price makes new highs but the DPO makes lower highs, it may suggest a weakening momentum.

• Overbought and Oversold Regions: Regions where the DPO remains above the zero line indicate overbought areas. These are where price peaks occur. Conversely, the areas in red where the DPO remains below the zero line indicate oversold markets, where price troughs may occur.

Conclusion

If you generally rely on trend-based technical indicators, the detrended oscillator may be a new way to look at price movements. To gain more experience in analysing this indicator and making trading decisions based on its values, you can use a trading simulator initially. Then, once you get better at interpreting numerical DPO values and their visual representation on price charts, you can plan your trades based on what the detrended price oscillator conveys about potential short-term trading opportunities.

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