The disparity index (or disparity ratio), compares, as a percentage, the latest close to a chosen moving average. For example, when the 13-week disparity index is -25%, it means that the market, based on the close, is 25% under the 13-week moving average. A 200-day disparity index of +12% means that the current close is 12% above the 200-day moving average.

The Japanese will say, for example, that “the separation between the price and the 13-week moving average expanded to 50%” or “that the market was an unusual 31% below its 13-week moving average.” These are references to the disparity index in which the current price is compared to, in both of these cases, the 13-week moving average.

Exhibit 5.3 shows an example using a 9-day disparity index. Looking at that exhibit:

Area 1. When the disparity index is at 0 (shown at 1), it means that today’s price is the same as the chosen moving average (in this case, the 9-day moving average).

Area 2. When the disparity line is under 0, it means that today’s price is a percentage under the chosen moving average. At period 2, for instance, the current close is 12% below the 9-day moving average.

Area 3. When the disparity line is above 0, it means that today’s price is a certain percentage above the chosen moving average. For instance, at point 3 in Exhibit 5.3, today’s price is 15% above the 9-day moving average.

Trading with the Disparity Index

The market should be at a high or low price before acting on a candlestick reversal pattern.

An example: “The probability is high that at a low-price level, a harami cross is a signal that the bottom is near and a harami cross at a high-price level is a signal that the market is close to a top.

Another example: “If the koma (this the Japanese term for a spinning top or a small real body candle) appears after some indication that the market is at a low price, then to an extent, one can buy some and feel at ease.”

Of course, the question arises as to what constitutes a high or low price area. Some traders have their own methodology to determine whether the market is at a high or low price. They may, for example, consider it at a low area if the market is near a major support area, or if it is at a 50% retracement area. Other traders may gauge high or low levels on the relative strength index or stochastics, or on an Elliott wave count.

A method use by some Japanese to determine whether the market is at a high or low price is by using the disparity index. This is because the disparity index is an effective mechanism to show if the market is oversold or overbought. Remember that an oversold environment unfolds when prices descend too quickly. In theory, the more oversold the market, the more vulnerable it becomes to a bounce. An overbought market is when prices ascend too far too fast, this making the market susceptible to a correction. In this regard, a high disparity index reading can show that the market is overbought and a low disparity index could reflect an over sold market.

Exhibit 5.4 typifies how the disparity index can offer value-added analysis to a candle chart. Note that an oversold or overbought indication based on the disparity index will depend on the individual market and the chosen disparity index. For this stock, when the 13-week disparity index reached the +10% area, the market became overbought. At a disparity index near -10%, the market becomes oversold. By using this extra information imparted by the disparity ratio in Exhibit 5.4, we can get more confirmation of candle signals. Specifically:

  1. A doji becomes a more viable signal if it appears in an oversold or overbought market environment. In this case, the doji at 1 emerged at a time when the market was oversold (as gauged by the disparity index). This hinted that Delta was ripe for a bounce or sideways action to ease the market’s oversold condition. The long white candle after the doji helped confirm the bullish implications.

2. At time period 2, the market showed signs of overheating, as reflected by the high disparity index. During the same period, a series of long upper shadow candles demonstrated that the bears were aggressively dragging down prices from the $75 area.

3. The candle at session 3, with its long upper and lower shadow, was a high-wave candle. This candle was also the second session of a harami pattern. Both of these were signs that the market was losing its prior downward and directional bias. These candle patterns coincided with a low disparity index. This combination of candle signals and the oversold disparity index reading implied that either a bounce or sideways activity could be expected. An oversold condition can be relieved in one of the two ways: either by a sharp bounce or by sideways action (the Japanese call sideways price activity box action since prices look like they are locked in a box). After this harami, the market traded laterally for two months. By this Box Action, the disparity index moved off its low reading. This showed that the market was no longer oversold. As a result of not being oversold, the market once again became vulnerable to another move lower. (Note the hanging man before the renewed price decline).

4. Another doji appeared at the same time as the 13-week disparity index was near -10%. This should tell a trader that the market was in an oversold environment that should be closely monitored, especially because of the doji. The tall white candle on the session after the doji completed a morning doji star pattern.

5. The disparity index moving towards an overbought condition and a dark cloud cover warned that the upside drive was losing force.

6. This is a good example of how the disparity index can help avoid buying in a market that is vulnerable to a correction. A tall white candle at 6 implied a stronger market lay ahead. However, a +10% disparity index reading at that time showed that prices had ascended too far too fast (i.e. became overbought). The disparity index thus provided a warning sign not to buy the market. It turns out that candle 6 completed a last engulfing top pattern (in which a white candle envelops a black candle in an uptrend) that was confirmed by the next session’s weaker close.

7. & 8. These black real bodies, especially, the long black body at 8, normally imply continued weakness. But the oversold nature of the market, as measured by the disparity index, hinted that further down moves were unlikely. Also, the white candle after the black candle at 7 had a long lower shadow. This also offset some of the bearishness of the black candle.

9. A classic combination of an overheated market (based on the elevated disparity index) and a bearish candle pattern (the bearish engulfing pattern). The fact that this bearish engulfing pattern appeared at the resistance area from October 1992 (at 6) further reinforced the outlook that Delta was at an important technical juncture.

10. Here we see how an oversold market joined with a bullish candle signal *the hammer at 10) strongly hinted of higher prices to come.

In this chart, the 13-weel disparity index gave extreme readings in the plus/minus 10% area. However, the markets you follow will probably have different disparity zones that act as an overbought or oversold reading so it pays to experiment.

As discussed above, the disparity index is a useful tool to weigh whether the market is overbought or oversold. As shown in Exhibit 5.5, the plus/minus 15% readings on the 13-period disparity index reflect times when this market becomes overbought and oversold.

Overbought readings occurred at time frames A, C and E, while oversold indications arrived at time frames B, D and F. However, in between these overbought and oversold levels, the disparity index could be used as a tool of trend determination. In this context, while the disparity index is expanding, it conveys a bull trend. If the disparity index declines, it echoes a bear trend. In Exhibit 5.5, note that between the overbought reading at A and the oversold reading at B, the index was in downtrend. This confirmed that the price trend was also down. This bearish confirmation with a falling disparity index came from C and D and from E to F. Bull trends were corroborated via an ascending disparity index from B to C and from D to E.

Exhibit 5.6 shows another use for the disparity index, that of a tool to monitor divergence. Note the downward sloping dashed line on the disparity index connecting the peaks at A and B. At the same time the disparity index was at B, prices had made a new high for the move – yet the disparity index at B was lower than it was at A. This created a bearish negative divergence in which prices reached a new high and the disparity index did not.

Source/Credit : Steve Nison