When the price enters the red sigma zone, this indicates that the price has probably become extremely “extended” in one direction – and that there is a probability that it could revert back to the mean (i.e. pullback to the blue zone). When price moves into the upper red sigma zone, this can indicate the price is extremely “overbought”. When price moves into the lower red sigma zone, this can indicate the price is extremely “oversold”. Usually, on balance of probabilities, when price enters the red sigma zones, there is a likelihood that price could revert back to the blue zone (i.e. reversion back to the mean) – although there is no certainty of this happening, but only a probability. For this reason we prefer to combine Sigma with momentum – i.e. the sigma wave momentum dots.
The yellow sigma zone denotes when price is moderately overbought/oversold (depending on whether it is the upper or lower yellow zone respectively). The blue zone shows the mid-levels. The indicator has a feature which shows “green” dots in the middle of the red zones – this usually indicates the middle of the red zone, which is often the likely or probable levels where price may test. There is also a “white” or “yellow” dot which is beyond the red zone – this shows 2 standard deviations beyond the green dot , an indication of increasing risk in case the price moves beyond the green dot into the white dot region. A chartist can use the distance from the green dot to the white dot as a measure of risk (and to minimise risk) in case the price did not revert back to the mean from the red zone.
In some circumstances, such as when the momentum is strong, it is possible for the price to ignore the red sigma zone and continue moving beyond the red sigma zone (hence the risk and why it is important to minimise such risks).
As mentioned, we prefer to use LT sigma with momentum – i.e. the sigma wave momentum. The sigma wave momentum is a simple momentum based indicator (similar to ) which can help show us the likely path of least resistance and the strongest trend. When the sigma wave momentum is above zero and increasing (i.e. ), it is shown ABOVE the sigma indicator as a blue dot (in the lower panel indicator). This can indicate increasing momentum to the upside. Similarly when sigma wave momentum is below zero and increasing lower (i.e. ), it is shown below the sigma indicator as a blue dot, this can indicate increasing momentum to the downside. The grey dots on the sigma wave momentum denote dissipating or decreasing momentum.
To further increase probabilities, we prefer to use sigma with sigma wave momentum (which can act as a sigma “filter”). If the sigma wave momentum dot is blue and in the LOWER section (i.e. below the sigma indicator), and the price on the sigma enters the upper red sigma zone, the probability is usually higher for the price to drop and fall back to the mean (revert to the mean) – meaning pullback back to the sigma blue zone. Vice versa applies: if sigma momentum dot is blue and in the UPPER section (i.e. above the sigma indicator) and price then enters the lower red sigma zone, the probability is usually higher for the price to bounce and revert back to the mean – meaning pullback to the blue sigma zone.
The probabilities are different and lower if the sigma wave momentum does not align with the sigma indicator. For example, if price is rallying higher and the sigma wave momentum dot is (i.e. blue and above the sigma indicator) then the odds of a reversion to the mean is lower. Similarly if price is dropping and the sigma wave momentum dot is (i.e. blue and below the sigma indicator) then the odds of a reversion the mean is lower. The grey dots denote dissipating momentum so they would be irrelevant in this context.
When using the indicator on very volatile markets such as cryptos, metals, individual stocks and lower timeframe charts, it is better to apply the strict criteria filter in the settings.
Chartists should be aware of the probabilistic and uncertain nature of price action and the markets, and therefore prepare to limit and control any potential risks. The indicator can be used on the charts of the majority of markets (e.g. stocks, indices, ETFs, currencies, cryptocurrencies, precious metals, etc.) and any timeframe. It should be noted that the degree of noise and randomness increases significantly on lower timeframes. So the lower the timeframe that is chosen (e.g. 15-min or lower) the greater the degree of noise and randomness and therefore the higher the frequency of false signals or whipsaws. The indicator can be applied to and OHLC bar charts.
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