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Created by Dr. Rene Koch, the variance ratio indicator measures the degree of mean reversion or trendiness in a time series. It is an easy and fast way to detect whether a security or price series is trending, mean reverting or following a random walk.
The variance ratio interpretation is as follow:
Above 1: The series is showing a tendency to form trends. This means that the series is likely to move in the same direction (compared to previous direction).
Below 1: The series is showing some degree of mean reversion. This means that series is likely to move in the opposite direction.
Equal to 1: This series is following a random walk. This means that it is impossible to predict the direction of the underlying security.
The trading indicator gets three parameters, which are a price series, a lookback period (to calculate return) and another period to use when calculating standard deviations.
Example:
test1 = VarianceRatio(close, 40, 200) > 1;
Check whether the security shows a tendency to form trends or not.
test2 = VarianceRatio(close, 40, 200) > 0.95 and VarianceRatio(close, 40, 200) < 1.05;
Check whether the security is following a random walk or not. We can include this rule in a trading system to ignore these unpredictable types of price series.
