Technical indicators can be useful. But, many indicators require a subjective evaluation. This makes technical indicators challenging to use.
Indicators or trading tools can be broadly classified as subjective or objective. A subjective tool is one that requires some degree of interpretation. For example, when looking at divergences, a popular tool for analyzing indicators, subjective judgments must be made.
Objective indicators offer clear signals defined by rules that are known in advance. Moving averages are popular objective indicators. A less well known objective indicator is the AROON indicator.
Traders may find there is value in exploring indicators that are not widely followed. The reason for that is simply that the indicator may add value to their investment performance. In general, the best known and most popular indicators are unlikely to beat the market by themselves.
That makes sense. If simple and popular indicators did work well, every trader would be able to beat the market and that is simply not how the market works. Therefore, it is logical that beating the market requires some effort and that effort includes researching less well known trading tools.
Defining AROON
Before turning to how AROON is calculated, we will start with a chart. The indicator consists of two lines which are shown at the bottom of the chart of SPDR S&P 500 ETF (NYSE: SPY) below.
The indicator consists of two lines. Signals are given when the lines cross. The latest sell signal in SPY came one day before the stock market sold off sharply. Now that you’ve seen how AROON can work, let’s look at how it is found.
There are two AROON lines, one based on the highs and one based on lows. The formulas are shown below:
AROON(Up) = ((N – X) / N) * 100
Where N = the number of days used in the calculation with 25 days being the default
X = the number of days since the most recent N-day high
AROON(Down) = ((N – Y) / N) * 100
Where N = the number of days used in the calculation with 25 days being the default
Y = the number of days since the most recent N-day low
The default value used in the calculation is 25 days. This was selected by the indicator’s developer, Tushar Chande. When introducing the indicator, Chande also explained where the name came from:
“In Sanskrit, AROON is the word for dawn’s early light, the first sign of a new day or a change from night to day. Thus, "AROON" is an apt name for an indicator that is sensitive to the beginning of a new trend.”
Specifically, AROON is designed to show you a trend’s first light on the chart.
Applying AROON
The next chart shows Invesco QQQ Trust (Nasdaq: QQQ) with AROON at the bottom of the chart. Boxes show the trading signals. Green boxes highlight winning trades. This is a long only strategy that is shown in the chart.
On its own, AROON can be useful. With the default value of 25, the indicator is best applied to daily data. This parameter may be too slow for weekly data and traders using longer time periods for their charts should consider shorter parameters for the indicator.
Now, even though AROON is useful, it is not 100% accurate and losing trades will occur. The next chart shows the iShares Russell 2000 ETF (NYSE: IWM) and highlights a series of losing trades.
In back testing, this simple indicator, using the default parameter would have delivered 14 buy signals in the past twenty years and 8 would have been winners (57.1%). Overall, the gains were larger than the losses but the biggest losing trade was more than 30% indicating this is an indicator that carries risk.
There are tools traders can consider to reduce risks. For example, the trader could use different parameters for calculating AROON.
Using 22 days, for example, increases the win rate to 80% and increases the amount of the gains. This is a value that can be considered to be the average number of trading days in one month and therefore is one that traders should always consider.
Calculating AROON with 22 days did result in an additional trade so it is not an example of curve fitting the calculation to find the absolute best value.
Other Tools For Managing Risk
Changing the calculation parameter is just one strategy for improving AROON to develop a trading strategy based on the indicator. Other tools include:
- Limiting trading to stocks that offer value since value stocks with momentum are likely to outperform the broad market in the long run.
- Adding a stop loss rule to close losing trades before the loss becomes too large.
- Closing trades after a certain amount of time if they have not delivered a sufficient gain to avoid giving the trade time to develop into a significant loss.
- Filtering trading signals with a moving average and, for example, only accepting buy signals when the closing price of the S&P 500 or of the stock or ETF being traded is above the 200 day moving average.
This is just a starting point and other tools are available that can reduce risk for traders.
But, all tools will require time and commitment to use. Many individuals discover that they are not able to complete the required amount of research because that can take an extended amount of time and they have other personal and professional commitments competing for their time.
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