Mass Index Trading Strategy – Backtest and Example
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 trading strategy?
The mass index trading strategy 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.
Related reading: Trading indicators
In this post, we take a look at the mass index strategy, and we make a backtest of the strategy.
Key takeaways
The mass index is a volatility indicator that measures the range between high and low stock prices over a specific time period. It is used to assess trend strength and predict potential reversals.
- Key Features: Introduced in the early 1990s. Analyzes the narrowing and widening of trading ranges to identify reversals based on unique market patterns.
- Chart Appearance: Displays as a line similar to the Accumulation/Distribution indicator or Relative Strength Index (RSI). Functions like the ADX by signaling reversals without indicating their direction.
- Usage: Does not provide directional insight, so analysts often pair it with directional indicators like the RSI.
- We show you a complete Mass Index trading strategy complete with trading rules.
- If you want to look at other indicators, please read our take on the top 10 trading indicators.
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.
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:
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.
- Take the single exponential moving average, EMA, as the 9-period EMA of the range (difference between the high and low).
- Take the double EMA of the range.
- Then take the EMA ratio by dividing the single EMA in (1) by the double EMA in (2).
- Finally, the mass index is calculated by taking the sum of the EMA ratio of the last 25 periods.
Related reading: Trading System
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 and backtest – does it work?
Let’s backtest the Mass Index with trading rules and settings and look at its performance. Our first backtest uses moving averages of 9 and 18 days.
We don’t want to use arbitrary and non-dynamic settings for our buy and sell parameters, and thus, we use the Relative Strength Index of the indicator.
Below is an example of what the RSI of the Mass Index Indicator looks like (the Mass Index is the middle pane and the RSI of the Mass Index is the lower pane):
Let’s look at a strategy where we buy when the Mass Index is oversold, and when the indicator is overbought, we sell.
We used the following trading rules:
- We make a 5-day RSI of the MASS Index indicator
- We buy at the close when the RSI closes below 25
- We sell at the close when the RSI closes above 75
The equity curve of the strategy looks like this on Chinese stocks (FXI):
The statistics and performance metrics are not much to get excited about: the 189 trades had an average gain of 0.83%, but the performance is pretty erratic. For example, max drawdown is almost 40% (how much drawdown is acceptable).
We backtested the same strategy on many other assets, but the results were not impressive. We even did strategy optimization on many assets, but the results never produced a profit factor of more than 1.7 (read more here about profit factor trading).
Mass Index backtest – divergence
We didn’t backtest the divergence strategy. The reason is simple: it’s a little complicated, and thus it takes too much time.
List of trading strategies
We have written over 1000 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The code for the backtested Mass Index strategy is included in the package.
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FAQ:
What is the mass index, and how does it differ from other volatility indicators?
The mass index is a volatility indicator that measures the range between high and low stock prices. It identifies potential reversals based on market patterns not easily visible to other indicators. Unlike directional indicators, the mass index does not show the direction of its signal.
How does the mass index indicator generate signals for trading?
The primary signal from the mass index is a “reversal bulge,” indicating a potential point of reversal in the market. Other signals include convergence and divergence, where divergence occurs when the indicator and price move in opposite directions, and convergence occurs when both rise and fall together.
How can the mass index be used for day trading and short-term trading techniques?
The mass index can be an effective tool for day trading and short-term trading techniques. Traders can consider pairing it with a more directional tool and should backtest the strategy to ensure its effectiveness in the specific market they want to trade.