The Adaptive Price Zone (APZ) is a volatility-based indicator that appears as a set of bands over a price chart. The APZ was developed in 2006 by technical analyst Lee Leibfarth to help traders identify potential turning points in the markets. Here, we take a look at the math behind the indicator, how it works and potential trading applications for the APZ.
The APZ is based on a double-smoothed exponential moving average that reacts quickly to price changes, with less lag than traditional moving averages. An exponential moving average (EMA) gives more weight, or value, to the most recent price data in the lookback period. In contrast, a simple moving average (SMA) gives equal weight to all data points in the lookback period. Because an EMA emphasizes the most recent price activity, it responds faster to price changes as they occur.
The adaptive component of the APZ stems from its use of an adaptive range to measure volatility, calculated by taking the five-period EMA of a five-period EMA of the current high minus the current low:
Volatility Value = 5-period EMA of 5-period EMA of (High – Low)
Next, this volatility value is multiplied by a deviation factor to draw the “upper” and “lower” APZ bands. The deviation factor affects how far the bands are from average price: Higher deviation factor values give price more room and lower values hug price more closely. Once the “volatility value” has been multiplied by the desired deviation factor, the volatility value is added to form the upper APZ band, and subtracted to draw the lower APZ band:
Upper APZ Band = (Volatility Value * Deviation Factor) + Volatility Value
Lower APZ Band = (Volatility Value * Deviation Factor) – Volatility Value
How it works
The APZ forms two bands that appear as an overlay on a price chart. The upper and lower APZ bands are not uniform or symmetrical.
In contrast, the bands take into consideration volatility, and vary in shape and width (the distance between the bands) as price changes occur. In general, the distance between the upper and lower APZ bands increases with larger price swings and more volatility; and decreases with smaller price swings and less volatility.
Price tends to stay within the APZ’s bands (see “Expand and contract,” below). When price does cross above or below one of the bands, it has deviated from its statistical average. Because price has a tendency to return to its statistical average inside the bands, traders can use the APZ to identify possible turning points: When price crosses above the upper band, a sell opportunity occurs; when price moves below the lower band, a buy opportunity arises. This is because of the statistical pull that moves price, from either direction, back within the APZ Bands.
Trading with APZ
The APZ can be applied to virtually any market or charting interval, and is particularly useful in choppy, non-trending markets. The lookback period (the number of price bars taken into consideration) and the deviation factor are both inputs that can be adjusted to suit a particular trading instrument, chart interval (for example, daily or five-minute), trading style and risk tolerance. The deviation setting has the greatest effect on the indicator because it sets the distance between the bands and average price.
For starters, a simple swing-trading strategy that uses the APZ would be to buy when price crosses below the lower APZ band, and to exit the trade when an opposing signal forms (at this point, this is a buy-only system).
To test this trading idea, we apply the basic strategy to the daily iShares Russell 2000 ETF (IWM), using the default lookback period of 21 and a deviation factor of 1.5 on the APZ. The results of this first run show promise, but the strategy performance report indicates the system suffers through large drawdowns (see “First run,” below). We’ll have to tune the strategy to minimize risk.