There are few scarier times in life than the moment you break away from societal norms to become your own person. Whether it is voicing your opinion to a group full of people who strongly disagree or it’s pursuing an idea that nobody else believes in. Doing these types of things are, in my humble opinion, what makes a person in today’s society brave. However, being brave isn’t everything in life. Some people are extremely good at following the trends of society and taking full advantage of them in order to get where they want, all while being conscious of what they are doing. People who do this are the people whom I consider wise. What does this have to do with investing? Everything. If you are going to manage your own money, or somebody else’s money, you have to be able to break away from societal norms and become a contrarian. This will give you the opportunity to make large sums of money when you are right and the crowd is wrong. Or, you can also be a trend follower, who isn’t much different than the contrarian in thought (wanting to take advantage of group think); however, their approaches to winning are different. Instead of betting that the whole crowd is wrong, the wise person understands that the crowd is irrational and uses that knowledge to take advantage of the situation by fitting in and understanding when the trends are reversing. Today we’re going to learn a tool to help you take advantage of the trends.
Case #2: Aroon Indicator
Last week, I wrote about Bollinger Bands and how to use them. Bollinger Bands are partially about following the trend, but they are more about seeing where prices are relative to their mean and if they are behaving abnormally. This week, I am writing about an indicator that is all about the trend of the security you are analyzing.
The Aroon indicator was developed by Tushar Chande in 1995 as a way to identify the beginning and ends of trends. In technical analysis, there are different areas where the “studies” may be performed in relation to the actual chart of the security. The Bollinger Band is used within the actual chart you are analyzing, whereas, the Aroon Indicator is a study that is conducted below the chart. The reason that the Aroon Indicator is below the chart is because it is scaled between 0 and 100, which means it is not scaled with the actual price of the security. We would not learn anything new by having the Aroon Indicator interacting with our actual chart; in fact, it would just be confusing.
The Aroon Indicator can be used for any time period that suits the way you trade; it can be 60 days or it can be 20 days, it’s all at your discretion. However, the standard time period for this technical tool is 25 periods. The reason I say periods instead of days is because you can trade on different time intervals than just days. A period in technical analysis equals one bar on the chart; therefore, those bars can be set to different time intervals based on your preferences. This works well if you day trade or if you trade monthly, it does not matter because the indicator scales to your time intervals.
Now that all the basics are covered, the Aroon Indicator is actually a very simple tool to use. As I mentioned before, it is scaled between 0 and 100 which makes it very easy to interpret. The indicator has two different moving lines that are always between 0 and 100. The line that indicates the uptrend is called Aroon up (I know, clever) and this is considered a bullish signal the higher it is. It is calculated as, {((number of periods) - (number of periods since highest high)) / (number of periods)} x 100. For example, let’s say we have 25 observation periods and the high value was 13 periods ago. The way it would be calculated is ((25-13)/25) x 100= 48. Now, in a vacuum that probably doesn’t mean much to you, and that is okay, we will get there. Next, we can calculate the Aroon down signal, which is a bearish signal the higher it is. It is calculated as, {((number of periods) - (number of periods since lowest low)) / (number of periods)} x 100, which is essentially the same formula with the only difference being subtracting the lowest low instead of the highest high. For example, let’s say the lowest low was 2 periods ago in our same 25-period example. The calculation would be ((25-2)/2) x 100=92. Therefore, we have an Aroon up of 48 and an Aroon down of 92, which way do you think this is trending? If you guessed down, then congrats, you are well on your way to making money.
Now, how do we interpret this indicator in a way that can make it a profitable tool? Well, to make money we first need to have a deep understanding of why we’re using this tool in the first place. The reasons are that we are looking for trends and trend reversals. The way we find trends is doing what we just did in the previous example. Without you knowing, we actually just used a tool called the Aroon Oscillator, which is just finding the numbers and then subtracting the Aroon up from the Aroon down to find if we are trending up or down. Therefore, our example had an Aroon up of 48 and an Aroon down of 92, which means that our Aroon Oscillator equals (48-92)= -44. Therefore, we are clearly on a down trend. We can use this oscillator to find the current trend, and the best part is that we can find the trend reversal when the oscillator goes from negative to positive or from positive to negative. Simply put, we can trade when the lines cross each other because that is a signal that the trend is reversing.
Easy right? Not so fast, because there are key values that you need to watch out for that are a little more in depth than the oscillator. The key values that need to be watched within the scale of 0 to 100 are 80 and 20. If a value, whether it’s Aroon up or Aroon down, reaches above 80 then it indicates that the up or down values are trending. If we have an Aroon up of 87 and an Aroon down of 18 then this is a clear uptrend that you need to take advantage of. However, if either the Aroon up or down hits 100 then it could be a signal that the trend is overbought and it could be a sign of a reversal. If an up or down value is below 20 then it means that it is not trending.
I will say this with every investing article; these tools cannot be used by themselves to make investment decisions. Investment decisions need to be approached in a holistic manner, and you need to take all these tools that you learn and come up with your own approach that works for you. You might find all the recipes in your cookbooks, but ultimately you will have to eat the food so you need to make it the way you like.
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How to Use the Aroon Indicator in Both Trending and Range Markets - Tradingsim. (2011, July 03). Retrieved March 24, 2017, from https://tradingsim.com/blog/aroon-indicator/
Ross, S. (2014, November 28). What is the Aroon indicator formula and how is the indicator calculated? Retrieved March 24, 2017, from http://www.investopedia.com/ask/answers/112814/what-aroon-indicator-formula-and-how-indicator-calculated.asp
Aroon Indicator. (2014, August 11). Retrieved March 24, 2017, from http://www.investopedia.com/terms/a/aroon.asp