As a forecasting tool, many traders value time as much as they value price. The Aroon indicator differs from other price momentum oscillators because it exploits both of these market attributes. Aroon-based indicators do this by measuring price changes relative to time. This article will examine the logic behind Aroon and show when it works best.
The Aroon indicator, popularized by technician Tushar Chande, can be used to determine a likely direction for a particular market on several different time frames. It can be used in forex, stock or commodity markets. Since Chande began discussing the indicator in 1995, it has been demonstrated to be effective, but remains less widely used than other indicators.
The name of the indicator comes from the Sanskrit word “aroon,” which means “dawn’s early light.” The name refers to the indicators’ intents, which are to signal trend changes early. The indicators consist of two lines, “Aroon Up” and “Aroon Down,” to show market direction.
In some respects, they bear many similarities to the directional movement index (DMI) by J. Welles Wilder that forms the basis for the ADX trend-strength indicator.
The two lines of the Aroon indicators form the basis of any trading strategy. Each line is given a range between 0 and 100. The “Aroon Up” line shows how upward strength in the market is being tracked and thus indicates whether the market will be upward- or downward-moving. The “Aroon Down” line shows downward strength in a similar way.
The best way to use the indicator is as a filter; in other words, longs should only be taken when Aroon Up is above Aroon Down, and shorts should only be taken when the inverse is true. The standard length for the Aroon Up and Aroon Down is 25 periods.
The Aroon indicator can be calculated using the following formula:
Aroon Up = ((25 - Days since 25-day high) / 25) x 100
Aroon Down = ((25 - Days since 25-day low) / 25) x 100
Looking at these formulas, it becomes apparent that they compare when the latest highs and lows occurred in recent market action. Higher Aroon values indicate more recent highs and lows, while lower values indicate less recent highs and lows. Moreover, the Aroon values oscillate between 0 and 100. A higher number in either indicates a stronger trend and vice versa.
The two Aroon indicators (bullish and bearish) can also be made into a single oscillator by making the bullish indicator 100 to 0 and the bearish indicator 0 to -100 and finding the difference between the two values. This oscillator then varies between 100 and -100, with 0 indicating no trend.
There are some very basic rules that traders can use by analyzing the relationship between the Aroon Up and Aroon Down. These involve three different conditions:
- Extreme readings
- Parallel movement between Aroon Up and Aroon Down
- Crossovers between Aroon Up and Aroon Down.
The Aroon indicator has a maximum value of 100 and a minimum value of 0. When the Aroon Up reaches 100, it is an early sign that traders are overly bullish and a counter move is likely. Conversely, when the Aroon Down reaches 100, it is an early sign that traders are overly bearish and a bounce is in order.
Buying and selling these extreme readings works best in markets that are range- bound. In trending markets, the Aroon lines will hover around 100 for a number of sessions, an indication that the current move is impulsive. During these impulsive moves, traders should add to their positions on any counter moves.
When the Aroon Up and Aroon Down lines run parallel to each other, it is a sign that the security is in a sideways consolidation period. This is often the case before a pending breakout. Traders should wait for the price and volume to increase in the security prior to initiating any new positions.
When the Aroon Up crosses above the Aroon Down, it is a sign of a potential bullish move. Conversely, a cross of the Aroon Down through the Aroon Up implies a bearish move is underway. In choppy markets, Aroon line crossovers will generate a number of false signals, so traders should use other indicators to confirm the strength of the cross.