Market indicators are an integral component of technical analysis. They help traders in making market decisions. Some indicators are designed to show the direction of a trend while others simply tell when a trend reversal is imminent. In this article, we look at one of the many trading indicators: the Aroon indicator.
The Aroon indicator is a trading tool that is used to determine trend changes in the price of a security and also to gauge the strength of that trend. It measures the time difference between market highs and lows over some time. It consists of two lines: Aroon-up and Aroon-down. We backtest an Aroon indicator strategy.
In this post, you will learn about the Aroon indicator and how it is used. Now let us dive in.
What is the Aroon Indicator?
The Aroon indicator is a technical analysis tool that is used to determine trend changes in the price of a security and also to gauge the strength of a trend. It measures the time difference between market highs and lows over some time. It consists of two lines: The Aroon-up line, which determines the strength of an uptrend, and the Aroon-down which determines the strength of a downtrend.
The logic behind this is that a strong uptrend will usually create new highs while a strong downtrend will create new lows. The line will show when this is happening and when it is not.
Also, the two lines tell you when a most recent high or low occurs. A higher value of the Aroon-up line indicates a recent high, while a higher value for the Aroon-down line indicates that a low has occurred. Higher values are an indication of a stronger trend. Lower values are an indication of a weaker trend or non-existence of a trend.
How do you calculate the Aroon indicator?
The formula for calculating the Aroon indicator is given below.
Aroon-up = ((25- Days since 25-day high)/25) x 100
Aroon-down = ((25 – Days since 25-day low)/25) x 100
The calculation above is based on 25 days, but you can, of course, set any number of days you want.
Calculations for the Aroon indicator require tracking the recent highs or lows within a 25-period interval. The steps are as follows:
Track the number of recent highs and lows for the prior 25 periods of security.
Note the distance between the recent high and low.
Input this number into the formula for Aroon-up and Aroon-down.
Interpreting the Aroon indicator: what does Aroon mean?
There are two levels: zero and 100. The Aroon-up and Aroon-down line usually oscillates between these levels. Values near 100 indicate a strong trend, while values near zero indicate a weak trend. The higher the Aroon-up, the stronger the uptrend and the weaker the downtrend, and vice versa. The basic theory behind the indicator is that during an uptrend, the price of an asset will make more recent highs, and during a downtrend, a more recent low.
The default preset of the indicator is 25 periods scaled to zero and 100. When the Aroon- up crosses above 50, it means that the price has a new high within the prior 12.5 periods. A reading near 100 means that a recent high was seen. The same applies to the Aroon-down. When the Aroon-down line is below 50, it means a new low has been made within the prior 12.5 periods. While a reading near 100 means that a recent low was witnessed.
When both lines are below 50, it means that the price is in a consolidation phase. Therefore, new highs and lows are not being created. Traders can use this to their advantage by looking for potential breakouts when the lines cross over to show which direction prices are headed.
Aroon indicator example
Let’s show you how the Aroon indicator looks in Amibroker (we coded the indicator ourselves):
The red line is Aroon up and the blue line is Aroon down (14 days). As you can see, it oscillates a lot up and down.
Who invented Aroon Indicator?
The Aroon indicator was created by Tushar Chande in 1995 as part of the Aroon Indicator system to identify short-term trends, as well as to gauge the strength of the trends. The name Aroon is derived from the Sanskrit language. It roughly translates to “dawn’s early light.”
Aroon Indicator Strategy: How traders use the indicator
The indicator can generate some trading signals. Crossovers strategy can be used for trading with this indicator. A bullish crossover is given when the Aroon-up crosses above the Aroon-down line. A bearish signal is given when the Aroon-up crosses below down.
However, the indicator is prone to fake-outs during volatile, range-bound action as seen on many momentum-based indicators. You must check for further confirmation from volume and price rather than on the indicator alone.
Another way to use the indicator is by reading the values. As already highlighted, values near +50 or -50 are considered a sign of a strong trend (single indicator version of Aroon). And values less than or equal to 30 are considered a weakness in the trend.
Aroon can also be used to determine overbought/oversold levels in the price of a given security. Very high values of Aroon-up (close to 100) are considered a warning bell to an imminent trend change or retracement in the market. An Aroon-up value at this level is interpreted as overbought. Whereas an Aroon-down value sustained at 100 may be interpreted as oversold conditions in the market; so, a rally should be expected afterward.
A warning note here: Don’t be eager to buy or sell when the indicator is in an overbought/oversold condition. As seen with other momentum indicators, prices can be in overbought/oversold conditions for a long period and prices will keep on going in the way of the trend without reversing in the short term. You must backtest the strategy to be sure it works before you put your money on the line.
Drawbacks (disadvantages) with the Aroon Indicator
The Aroon indicator can sometimes be resourceful in giving a good entry or exit. However, it sometimes produces false signals. The long or short trade signal may happen after the price has made a substantial move and this is because the indicator relies on historical data to compute its value.
While a crossover strategy might look good on the Aroon indicator, it does not guarantee a significant price move since the indicator is only concerned about the distance between a recent high and a recent low. A major pitfall of the crossover is during the range-bound market when the indicator will generate a signal based on a recent high or low within the prior 25 periods.
Aroon Indicator Trading Strategy no 1
Let’s backtest an Aroon indicator trading strategy on S&P 500 (SPY). We use the following criteria for our backtest:
- We use a period of 14 days.
- We buy when the Aroon Down is below 10.
- We sell when the AroonDown is above 50.
This is a classical mean reversion strategy.
The equity curve looks like this:
Aroon Indicator Trading Strategy no 2
We did a small twist to the Aroon strategy: we used a moving average of the Aroon indicator and added a second indicator as a trend filter. That improved the strategy a lot:
Aroon indicator in Amibroker
We use Amibroker and the Aroon indicator doesn’t come with the software. We coded the indicator ourselves and you can get access to the code if you subscribe to all our code for all robust free trading strategies (articles where we have published the logic behind the strategy). If you order, you’ll also get access to Aroon indicator strategy no 2.
Aroon indicator strategy – ending remarks
We backtested many different Aroon indicator trading strategies, but only a few yielded good results. However, this might be a result of curve fitting, which you always have to watch out for. We tried both oscillating strategies and trend-following strategies, but few worked. Thus, there are many other indicators that are better than the Aroon indicator.