Mass Index Trading Strategy (Backtest And Example)

Last Updated on October 10, 2022 by Oddmund Groette

For many traders, a market with high volatility means more room for profit. There are many tools for tracking the volatility in the market, and the mass index is one of them. What is this mass index?

The mass index is a popular volatility indicator that measures the range between high and low stock prices (volatility) over a specified period of time. It is used to evaluate the strength of a trend and also when a reversal is about to take place.

In this post, we take a look at the mass index strategy and we make a backtest of the strategy.

What is the mass index?

The mass index is a popular volatility indicator that measures the range between high and low stock prices (volatility) over a specified period of time. It is used to evaluate the strength of a trend and also when a reversal is about to take place.

Introduced in the early 1990s, the indicator analyzes the narrowing and widening of trading ranges to identify potential reversals based on market patterns that aren’t often visible to other price and volume indicators.

When plotted on the chart, the mass index appears as a line that looks similar to the Accumulation/Distribution indicator or the Relative Strength Index (RSI), but it acts like the ADX in that it does not show the direction of its signal. Given that the indicator does not provide insight into the direction of the reversals, analysts combine it with directional indicators, such as the RSI.

Mass index indicator example

To help make sense of all that was explained in the previous section, let us take a look at the mass index indicator on a real chart.

Mass index indicator example
The daily chart of EUR/USD: Mass index example.

See the mass index in the indicator window of the chart above. The default setting for the index is 10 though you can tweak the period to align with your trading strategy. Although the mass index looks similar to the RSI and other momentum indicators, the interpretation is quite different. According to Donald Dorsey, the two most important numbers are 27 and 26.5 when reading the mass index. He noted that a trend reversal will most times occur when the index rises above 27 and then moves below 26.5; he termed this phenomenon a reverse bulge.

However modified versions of the indicator available in trading platforms, such as the TradingView does not have values in the 20s range. A reverse bulge might be said to occur even at 11. See an example in the charts below:

Mass index strategy
Mass index strategy: The reverse bulge on the 4h chart of EUR/USD.
Mass index trading strategy example

Notice that, in the first chart, the reverse bulge formed when the price was about to make a downward reversal. In the second chart, it formed when the price was about to reverse upwards from a pullback. This shows that it is not direction-sensitive.

An effective method for trading the mass index is by taking into consideration the current price action or by pairing it with a more directional tool. The rise and fall of the index are not in tandem with the price. For instance, you should not take rising volatility as a signal to enter a long trade because volatility can go up and down regardless of the trend in place.

Who invented the Mass index indicator?

Donald Dorsey developed the mass index in the 1990s. He claimed the indicator looks at the repetitive patterns in the market and helps to spot when security is experiencing expansion or contraction in its trading range. The indicator is a helpful tool for identifying trends and reversals. As with most volatility-based indicators, the mass index works great in a trending market when used to track the end of a pullback or the end of an impulse wave.

What is the mass index indicator formula?

The mass index calculation is pretty straightforward. The steps for calculating the index are given below.

  1. Take the single exponential moving average, EMA as the 9-period EMA of the range (difference between the high and low).
  2. Take the double EMA of the range.
  3. Then take the EMA ratio by dividing the single EMA in (1) by the double EMA in (2).
  4. Finally, the mass index is calculated by taking the sum of the EMA ratio of the last 25 periods.

How can you trade the mass index indicator? (Trading rules and settings)

As mentioned earlier, the first and most basic signal from the mass index indicator is a reversal bulge. This signal is primarily used to identify a potential point of reversal in the market. It is not difficult to spot on the chart which means that it would not be a problem whether you are a new or experienced trader.

Other signals generated by the mass index are convergence and divergence. Divergence occurs when the indicator and price are moving in the opposite direction. In contrast, convergence is what it sounds like — both the indicator and price rise and fall together. So, when the price is rising and the indicator is declining (divergence), it can be seen as a rally that is losing momentum whereas a rise in price with a rising mass index is seen as increased volatility of the uptrend, so when the indicator shifts to the downside you should anticipate a reversal or pullback from the uptrend.

The mass index indicator is not a directional tool, and as such, it should not be confused with a trend indicator. It does not show whether the price will go up or down so you should not sell when the indicator is down or buy when it goes up. The key signal is that a reversal may be about to occur if the indicator moves up and turns downward — you can only tell the type of reversal from the preceding price action.

The mass index will notify of a reversal regardless of the market condition (whether an uptrend, a downtrend, or a range). It does not matter the degree to which the reversal of the security will take place.

The mass index indicator can be a great tool for day trading and other short-term trading techniques. But make sure you backtest it first to be sure that it has an edge in the market you want to trade.

Mass index trading strategy example

Coming soon.

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