What Is the Fisher Transform Indicator?
The Fisher Transform is a technical indicator created by John F. Ehlers that converts prices into a Gaussian normal distribution. The indicator highlights when prices have moved to an extreme, based on recent prices. This may help in spotting turning points in the price of an asset. It also helps show the trend and isolate the price waves within a trend.
- The Fisher Transform is a technical indicator that normalizes asset prices, thus making turning points in price clearer.
- Some traders look for extreme readings to signal potential price reversal areas, while others watch for a change in direction of the Fisher Transform.
- The Fisher Transform formula is typically applied to price, but it can also be applied to other indicators.
- Asset prices are not normally distributed, so attempts to normalize prices via an indicator may not always provide reliable signals.
Understanding the Fisher Transform Indicator
The Fisher Transform enables traders to create a Gaussian normal distribution, which converts data that isn't typically normal distributed, such as market prices. In essence, 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 leading signals, rather than lagging indicators. The Fisher Transform can also be applied to other technical indicators, such as the relative strength index (RSI) or moving average convergence divergence (MACD).
The Fisher Transform Formula
Fisher Transform=21∗ln(1−X1+X)where:ln is the natural logarithmX=transformation of price to a level between -1 and 1
How to Calculate the Fisher Transform
- Choose a lookback period, such as nine periods. This is how many periods the Fisher Transform is applied to.
- Convert the prices of these periods to values between -1 and +1 and input for X, completing the calculations within the formula's brackets.
- Multiply by the natural log.
- Multiply the result by 0.5.
- Repeat the calculation as each near 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 prior calculated value.
The Fisher Transform Indicator Trading Applications
The Fisher Transform indicator is unbounded, which means extremes can occur for a long time. An extreme is based on the historical readings for the asset in question. For some assets, a high reading may be seven or eight, while a low reading may be -4. For another asset, these values may differ.
An extreme reading indicates the possibility of a reversal. This should be confirmed by the Fisher Transform changing direction. For example, following a strong price rise and the Fisher Transform reaching an extremely high level, when the Fisher Transform starts to head lower that could signal the price is going to drop, or has already started dropping.
The Fisher Transform frequently has a signal line attached to it. This is a moving average (MA) of the Fisher Transform value, so it moves slightly slower than the Fisher Transform line. When the Fisher Transform crosses the trigger line, it is used by some traders as a trade signal. For example, when the Fisher Transform drops below the signal line after hitting an extreme high, that could be used as a signal to sell a current long position.
As with many indicators, the Fisher will provide lots of trade signals, plenty of which are not profitable to follow. Therefore, some traders prefer to use the indicator in conjunction with trend analysis. For example, when the price is rising overall, use the Fisher Transform for buy and sell signals, but not for short-sell signals. Meanwhile, during a downtrend, use it for short-sell signals and ideas on when to cover.
The Fisher Transform Indicator vs. Bollinger Bands®
These two indicators look very different on a chart, yet both are based on a distribution of asset prices.
Bollinger Bands® use a normal distribution in that they use standard deviation to show when the price may be overextended. 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 overlayed over the price.
Limitations of the Fisher Transform Indicator
The indicator can be rather noisy at times, even though its intent is to make turning points easier to identify. Extreme readings are not always followed by a price reversal; sometimes the price just moves sideways or reverses only a small amount.
What qualifies as extreme can also be hard to judge, since the levels tend to vary over time. Four may be a high level for years, but then readings of eight may start to frequently appear.
Looking at all changes in direction on the Fisher Transform can help spot short-term changes in price direction. However, the signal may come too late to capitalize, as many of these price moves may be short-lived.
Asset prices are not normally distributed, therefore attempts to normalize prices could be inherently flawed and may not produce reliable signals.