Pros and Cons of Williams %R Indicator

Apr. 27, 2011 8:23 AM ET

327 Followers

Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

http://www.invest2success.com

Long/Short Equity, Special Situations, Growth, Growth At A Reasonable Price

Seeking Alpha Analyst Since 2007

Michael Michaud is the founder owner of Invest2Success.com (http://www.invest2success.com/). He has been investing and trading in the financial markets since 1989.

He founded Invest2Success.com to empower independent and institutional investors traders to take control of their financial destiny by providing them education training mentorship and support for them to research analyze invest and trade in the markets successfully in the long-term.

As he says, "With knowledge, dated goals, a plan of action, then taking action, profitable investing and trading success will only be a matter of time."

An In-depth Look at Williams %R’s Assets and Shortcomings Understanding The Williams %R Indicator

by Ken Long of the Van Tharp International Institute of Trading Mastery

Click here for Dr. Van Tharp's Trading Workshop Schedule

The Williams %R Indicator

Oscillators are technical analysis tools used to identify time periods when price can be considered to be in an overbought or oversold condition. Overbought and oversold conditions are found at extremes that vary based on how the oscillator is constructed. Some oscillators look exclusively at price with respect to the range of high and low in the look back period. Others incorporate some measures of statistical description. In most cases, the look back period is required in order to establish what may be considered normal and extreme for the price channel.

Depending on the market condition, your strategy could be one of channel trading in which case you expect price to reverse once it’s in this extreme condition or one of preparing for breakout trades in which case you expect price to continue explosively through this extreme moment and breakout of the channel.

The famous technical analyst, Larry Williams, created the Williams %R indicator as an index ranging from zero to -100 for the look back period. The highest high of the look back period earns an index score of zero and the lowest score earns a -100. Then, look back period is segmented into 100 equal sections and the oscillator value of the price is interpolated.

Readings between zero and -20 are considered to be overbought because they are in the top 20% of price, whereas readings between -80 and -100 are considered to be oversold because they are in the bottom 20% of price during the look back period. Readings between -20 and -80 are considered to be in the normal range of the channel.

Assets

Williams %R is my favorite oscillator because it is simple to understand and very visual.

I use Williams %R as a useful oscillator in determining if a particular instrument might be considered overbought or oversold based on the context of recent price action in a defined period. I like to use 10 days and one year for context.

I use the 10 days of look back to give me insights into short-term trader psychology and I use the one year look back period to give me insights into long-term trader psychology. In some of my systems I combine both of these measures to give me a consolidated, integrated look at market psychology.

There’s nothing magical about the use of these two specific time frames, nor do I believe that they have any predictive power. I simply find them useful to help me frame my trades and understand the market enough so that I can take action.

I have not exhaustively analyzed different time frames to see if there is an incremental advantage for adjusting the parameters. These two periods work well enough to get me into the ballpark for decent trading opportunities.

Recently, I have seen some trading systems with simple rule sets built exclusively from Williams %R that use a 30-period look back rather than the standard 10. I’ve only looked at the rule sets superficially: while the entries made sense, the exits looked clumsy and non-intuitive.

Shortcomings

Although I consider Williams %R an excellent technical indicator, it is by no means perfect. I dislike the scale because it seems counterintuitive to me. It goes from a high of zero to -100. I also don’t like that it uses today’s price action when calculating the index value. Normally, this is good enough; however, there are days when the price of the asset has makes a bold break out from the last 10 days trading range and this indicator doesn’t help me recognize the breakout.

If I were going to design this indicator from scratch, I would fix those two problems. First, I would make the scale read from 0 to 100 like a thermometer. Second, I would describe today’s price action on a normal scale of 0 to 100 that looked back 10 days starting from yesterday. For example, if today’s price exceeded the highest high of the last 10 days, the indicator would have a reading greater than 100. Conversely, if it had a lower low than the low of the last 10 days, it could have a negative reading. This change would allow you, by inspection, to identify breakout candidates in both directions as well as a relative magnitude of the breakout, depending on how far below 0 or how far above 100 the new reading stands.

Re-engineering An Indicator

To support my own trading I built such an indicator in Microsoft Excel and I use it for analyzing a large numbers of stocks and ETFs as part of my daily trading practice. I have found the modified indicator, which I call NDX (or “index”), does everything that Williams %R does and fixes its two shortcomings.

In my spreadsheet reports, I use the NDX(t), where “t” represents the look back timeframe. For example, NDX(10) would represent a 10-day look back period from yesterday to 11 days ago, with today being represented as the zero day.

If an instrument traded in a price range from $10 to $20 in the look back period, and closed today at a price of $10, it would have an index value of zero. If it closed today at $20, the index value would be 100. If the close today were $21, the index value would be 110, which would indicate a breakout of 10% greater than the previous trading range.

You can see how this information could be very useful scanning for breakout opportunities in a large population of stocks and ETFs. The normal 0 to 100 scale is also much more intuitive to me.

I use conditional formatting in Excel to highlight index values greater than 90 in green and less than 10 in red. I typically rank sets of symbols from highest to lowest or lowest to highest in order to find those at the most extreme condition compared to their peers. This is consistent with the use of oscillators in general, and I have found it very useful to focus on these extremes for short-term trading targets.

When I use a year-long look back timeframe, I write the column header as NDX(52w).

I still use Williams %R whenever I use commercial or public stock screeners. I use my NDX indicator on my spreadsheet reports.

These kinds of refinements come from a deep understanding and appreciation for the construction, use and limitations of conventional technical analysis. The refinements don’t seem important unless you understand a specific indicator at a deep level. Attention to detail will reward your practice of trading.

Click here to review more trading information and resources from the Van Tharp International Institute of Trading Mastery

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Recommended For You