Choppiness Index by Bill Dreiss – Trading Strategy (Rules And Returns)

Ascertaining the market condition is often necessary but can be very difficult, which is why the choppiness index can be very powerful for your trading. What do you know about the choppiness index?

The Choppiness Index is an indicator created by an Australian commodity trader, Bill Dreiss, to show when a market is choppy or trending. A choppy market is one that is ranging or in a tight consolidation. The indicator is assigned values from 0 to 100, with low values indicating a high degree of choppiness in the market and high values signaling a possible trending condition.

In this post, we will take a look at everything you need to know about this indicator: what it is, how it works, and how you can use it to improve your trading strategies. Keep reading!

Key takeaways

• The Choppiness Index signals choppy or trending markets.
• The indicator ranges from 0 to 100 – the lower the value, the less trending.
• We provide you with a specific example of a trading strategy based on the Choppiness Index.

What is the Choppiness Index?

The Choppiness Index is a technical analysis indicator that can help you determine when a market is choppy or trending. A choppy market is one that is ranging or in a tight consolidation. The indicator was created by an Australian commodity trader, Bill Dreiss, to show whether a market is moving in a trend or just sideways.

The indicator is assigned values from 0 to 100. High values indicate a high degree of choppiness in the market, while low values signal a possible trending condition. The higher the value, the higher the choppiness, and the lower the value, the more likely the market is in a trend. However, traders often use a cutoff level to mark trending and choppy markets. A value of 38% and below indicates a trending market, while a value of 62% and above indicates a choppy market.

How does the Choppiness Index measure market volatility?

The Choppiness Index measures market volatility by considering the range between the highest-high and the lowest-low prices over a given period and multiplying with the sum of ATR over that period. Then a log function is used to normalize the result to a value between 0 and 100. Higher values indicate that the market is choppy, while lower values indicate that the market may be trending.

You can get the choppiness index of any period or timeframe you want. The period you used would depend on your preference and the market you’re studying. However, the shorter the period, the more likely the value would be in the choppiness range, which is usually values above 62%.

Choppiness Index trading strategy – trading rules, backtest, Returns, and performance

We have now explained the basics of the Choppiness Index. Is it useful? Our intuition says that such an indicator might be good for gold (GLD) because commodities tend to continue in the direction of large moves.

We backtest SPY, the ETF that tracks the S&P 500, and we make the following trading rules:

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We employ the trading rules on the S&P 500 (SPY) from its inception until today and get the following equity curve:

The average is 0.64% per trade. The strategy is invested only 15% of the time, and still, it generates almost 8% annually. We believe this is pretty good! The risk adjusted return is around 5 times higher than buy and hold.

The facts, statistics, and trading performance are summarized like this (the most important metrics are highlighted):

Let’s change one of the trading rules:

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If we flip the Choppiness Index filter, we get the following equity curve:

The average drops to 0.17% per trade. Thus, it seems the Choppiness Index might offer some value.

Why is the Choppiness Index important for traders?

The Choppiness Index is important for traders because it tells them the market condition — whether the market is choppy or trending. This helps them decide on whether to trade or not and what strategy to use.

Most traders don’t like to trade choppy markets because the non-directional price movements can easily hit their stop-loss orders. So, they like to know when the market is choppy and avoid trading during that period. Even those who have strategies to trade a choppy (range-bound) market would want to know when the market is ranging to know the strategy to use.

While the choppiness index cannot tell the market direction — just like the average direction movement index (ADX) — it is still very useful to traders who want to know the market condition.

What are the key components of the Choppiness Index formula?

The key components of the choppiness index formula are as follows:

• The specified period length
• Average true range (ATR) of period 1
• The price high over the period under study
• The price low over the period under study
• The Log₁₀ of the period

Essentially, the main variables are the range between the highest-high and the lowest-low prices over a given period and the sum of ATR over that period.

How is the Choppiness Index calculated?

The Choppiness Index is calculated through the following formula:

Choppiness Index = 100 x LOG10[∑ (ATR(1), n)/( MaxHigh( n) − MinLow( n)] / LOG10( n)

Where:

Log10( n) = base-10 Log of n

n = the specified length of the period

ATR(1) = Average True Range ( Period of 1)

SUM( ATR(1), n) = Sum of the Average True Range over n periods

MaxHigh(n) = The highest peak over n periods

MinLow(n) = The lowest trough over n periods

Here are the steps for calculating the choppiness index:

1. Get the lowest True Low and the highest True High for n periods.
2. Subtract the lowest True Low from the highest True High.
3. Sum True Range for the past n periods.
4. Divide by the result of step 2 above.
5. Calculate Log10 of the result of step 4, and then, Multiply by 100.
6. Divide the result by Log10 of n.

Can the Choppiness Index help identify trend strength?

Yes, the choppiness index can help identify trend strength but not directly like the ADX indicator. The primary job of the choppiness index is to measure the degree of choppiness in the market, and that is what it measures directly. The higher the value of the indicator, the more choppiness in the market.

However, it measures the strength of the trend indirectly. The opposite end of the indicator’s value spectrum shows the trendiness in the market. That is, the lower the choppiness index value, the stronger the trend.

How does the Choppiness Index differ from other volatility indicators?

The Choppiness Index differs from other volatility indicators in that it is designed to determine whether the market is choppy or not choppy, and not to measure the size of price swings as the others do. For example, the ATR directly measures price range, while Bollinger bands indirectly shows the size of the consolidation. Even standard deviation shows the extent of the price swings.

Another difference is that the choppiness indicator is not directional at all. It does not show market direction. It only tells you whether the market is choppy or trending.

Read More About Technical Indicators

What are the typical values of the Choppiness Index?

The typical values of the choppiness index range from 0 to 100. The reason is that, in the formula, the log function and the multiplication by a factor of 100 were used to normalize the values to range between 0 and 100.

Values closer to zero denote trendiness in the market. On the other hand, values closer to 100 indicate choppiness in the market. It is up to the trader to choose the levels that best suit the market he or she is trading.

How can traders interpret the Choppiness Index readings?

To interpret the choppiness index, traders can choose the cutoff levels that best define the choppiness and trendiness of the market they are trading. As we already stated, the values of the index range between 0 and 100, and the higher the value, the choppier the market, and vice versa.

Many traders use the Fibonacci numbers 61.8% and 38.2% to set their cutoff levels, such that a reading above 61.8% is considered a very choppy market that is untradable; a reading between 38.2% and 68.1% is considered a sideways market for mean-reversion strategies; and a reading below 38.2% is considered a trending market for trend-based strategies.

What are the benefits of using the Choppiness Index in trading strategies?

The benefits of using the choppiness index in trading strategies are many. These are some of them:

• It tells traders the prevailing market condition — whether the market is trending, ranging, or very choppy.
• It helps traders to decide whether to trade the market or not — trend traders can choose to stay away from ranging or choppy markets, while mean-reversion traders would know when to get into a ranging market.
• It helps traders to know which strategy to use in any market condition — traders who use different strategies would know when to use a trend-following strategy and when to use a mean-reversion strategy.

Are there any limitations to the Choppiness Index?

Yes, there are many limitations to the choppiness index. Here are some of them:

• The indicator does not show the direction the market is moving, so you can’t use it to predict market direction.
• It lags a lot, as its values are calculated from what has already happened in the price action.
• It cannot tell when the market conditions would change. It may show that the market is trending and by the time you get into a trade, the market condition may change to choppiness.

How frequently should traders monitor the Choppiness Index?

How frequently traders should monitor the choppiness index depends on the market they are trading and how often the market condition changes. In markets that trend for a long time, the trader may choose not to monitor the indicator frequently.

It also depends on the trader’s style of trading. Intraday traders would definitely have to monitor the indicator more frequently than a swing trader and a position trader. While a position trader may check the indicator once a week, a swing trader may have to check it once a day, and a day trader may monitor it every hour.

What trading strategies can be enhanced with the Choppiness Index?

Almost every trading strategy can be enhanced with the choppiness index. The reason is that the indicator tells you the prevailing condition of the market so you determine whether it is suitable for your trading strategy or not.

For trend-following strategies, the choppiness index can indicate when the market is trending and, thus, suitable for such strategies. The same is true of mean-reversion strategies — the index can show when the market is ranging and, thus, suitable for them.

Can the Choppiness Index be used in conjunction with other indicators?

Yes, the choppiness index can be used with other indicators to get the best out of those indicators. The index, itself, cannot be used to predict the market direction or find the right entry — it only shows the market condition. So, it must be used with other indicators that can perform those functions.

Since the index shows the condition of the market, you can combine it with any indicator that shows the direction of the trend or oscillators that show potential reversal points.

How does the Choppiness Index help traders manage risk?

The choppiness index does not directly help traders to manage risk, as it neither tells them how much position size to use, nor which level to keep their stop-loss order. However, it can tell them when favorable market conditions are present so they can find a way to enter or remain in the market and when unfavorable market conditions set in so they can get out of the market.

In essence, traders can use it to formulate a reasonable trading strategy that specifies the right amount to risk per trade, the appropriate position size per trade, and the right level for their stop-loss orders.

What are some real-world examples of the Choppiness Index in action?

Here are some real-world examples of the choppiness index in action:

Example 1: A choppy market:

In the chart below, you can see that the choppiness index stayed mostly above the 62% level, which indicates that the market is very choppy and, possibly, not tradable. As a trader, you may choose to stay away from the market. If you must trade it, you may step down to a lower timeframe and use a mean-reversion strategy.

Example 2: A trending market:

In the chart below, you can see that the choppiness index was staying mostly below the 38% level. This tells you that the market is trending and may likely remain so. In this case, you approach the market with a trend-following strategy.

How does the Choppiness Index adapt to different market conditions?

The choppiness index does not adapt to different market conditions on its own — it’s you, the trader, who ought to use it to identify the prevailing market conditions and adapt your strategy to suit the market condition you’re trading. If it tells you that the market is trending, you trade with a trend-following strategy. If it tells you that the market is ranging, you look to trade a mean-reversion strategy.

Can the Choppiness Index be customized for specific trading styles?

Yes, the choppiness index can be customized for specific trading styles. You can choose the timeframe that suits the specific trading style you want to trade. If you’re a day trader, you may set up the index in a H1, M30, or M15 timeframe so it shows you when the market is trending or ranging in that timeframe.

On the other hand, if your style is swing trading, you can set up the index on the H4 or D1 timeframe to know when the market is trending or ranging in that timeframe.

How does the Choppiness Index assist in decision-making during market uncertainty?

The choppiness index can assist you in decision-making during market uncertainty by showing you the prevailing conditions in the market. If its reading is lower than 38%, it tells you that the market is trending, so you decide to trade with only a trend-following strategy.

On the other hand, if its reading is above 38%, it tells you that the market is ranging, and you may choose to trade a mean-reversion strategy or stay away from the market.

What historical significance does the Choppiness Index hold in financial markets?

The Choppiness Index holds a significant history in the financial markets. It was created in the early 1990s by an Australian commodity trader, Bill Dreiss. He first introduced the index in an article he published in the July/August 1992 edition of Commodity Traders Consumer Report titled: “The Fractal Wave Algorithm, Charts, And Systems”.

Since then, the indicator has been used by many traders who like to know the condition of the market before they trade. However, in spite of the usefulness of the indicator, it is not usually present in most popular trading platforms. In recent times, though, there have been custom versions of the indicator for MT4 and TradingView created by traders who like to use it.

How do traders incorporate the Choppiness Index into their trading plans?

Traders incorporate the choppiness index in their trading plans by using it to understand the condition of the market so as to know the strategy they can use at that moment. For example, a reading of less than 38%, tells them that the market is trending, so they trade with only trend-following strategies.

Similarly, a reading of above 38% could tell that the market is ranging, so they may choose to trade a mean-reversion strategy or stay away from the market.

What are the common misconceptions about the Choppiness Index?

The common misconceptions about the choppiness index are as follows:

• The choppiness index can tell you the direction of the market: The index was created to tell you whether the market is choppy or trending. It does not indicate the market direction.
• The choppiness index tells you whether the market is oversold or overbought: Because the indicator comes with some market levels at 38% and 62%, one may confuse those levels as oversold and overbought levels. However, it only indicates the choppiness or trendiness of the market.
• The choppiness index tells you when to enter the market: The indicator only tells you the market condition so you know which strategy to use.

How does the Choppiness Index contribute to technical analysis?

The choppiness index contributes immensely to technical analysis because it helps us to know the condition of the market. This is very important information, as it lets us know the kind of trading strategy that is more likely to work in the current market condition.

For instance, if you know that the market is ranging and likely to keep ranging for a while, you can focus your technical analysis on looking for opportunities for mean-reversion trades.

Can beginners easily grasp the concept of the Choppiness Index?

Yes, beginners can grasp the concept of the choppiness index, but as with any aspect of trading, it’s never going to be easy. They have to put in the work to understand what the indicator does and how to use it along with other indicators or price action to formulate a reliable trading strategy.

The key is to understand that the choppiness index only tells them the condition of the market so they can decide what to do next.

How can traders optimize their use of the Choppiness Index for profitable outcomes?

To optimize their use of the choppiness index for profitable outcomes, traders can use it to determine when to trade and when not to trade, as well as the type of strategy to use, given the market condition. If the choppiness index shows that the market is too choppy, the trader may choose to stay away from the market, but if it is just ranging, they may use a range-specific strategy. When the indicator shows that the market is trending, they know they have to use a trend-following strategy.