Most of the technical indicators that traders use nowadays we developed back in the 70, ’80s, and ’90s. However, the indicator we are going to introduce to you today was created not so long ago, in 2010. It’s called the Vortex indicator.
The Vortex indicator is a mean reversion oscillator that is used to spot trend reversals and current trends. Because of its popularity among traders, we asked ourselves: Can we develop a profitable trading strategy with it?
In this article, we are going to look at what the Vortex indicator is, how to calculate it, and develop a trading strategy with it.
Related reading:- Looking for a good trading strategy? (Hundreds in that link)
What is the Vortex indicator?
The Vortex Indicator is a technical analysis tool that seeks to help traders identify the beginning of a new trend and the strength of that trend. It was developed by Etienne Botes and Douglas Siepman in 2010. The indicator consists of two lines: the Positive Directional Movement Indicator (DMI+) and the Negative Directional Movement Indicator (DMI-).
How to calculate the Vortex indicator
The calculations of the Vortex indicator involve three components:
- True Range (TR): Max(High – Low, High – Previous Close, Previous Close – Low)
- Positive Movement (VM+): Absolute value of Current High – Previous High
- Negative Movement (VM-): Absolute value of Current Low – Previous Low
Then, you just have to use the True Range (TR) and the Sum of the last ‘n’ periods of VM+ and VM- to calculate the Vortex Indicator. Therefore, the formula for Vortex Indicator (VI) is:
VI+ = Sum of the last ‘n’ periods of VM+ / TR
VI- = Sum of the last ‘n’ periods of VM- / TR
Here is an example of the Vortex indicator on a chart:
Now that we know how to calculate it, it’s time to backtest a Vortex indicator trading strategy and see whether the indicator is profitable or not.
Vortex indicator trading strategy – trading rules
The trading strategy we are going to backtest is pretty simple:
- We buy the asset when VI+ < VI-
- We sell the asset when VI+ > VI-
Hence, the signals are generated when the lines intersect by moving below or above one another. Note that we used 100 days to calculate the moving averages of the VM+ and VM-.
Vortex indicator trading strategy – backtest
We are going to backtest the trading strategy using the ETF version of the S&P 500, SPY. The data is adjusted for dividends and splits. Here is the equity curve:
Here are some performance metrics and statistics about the strategy:
- CAGR is 5.27% (buy and hold 9.81%)
- Time spent in the market 48.76%
- Risk-adjusted return is 10.80% (CAGR divided by time spent in the market)
- Maximum drawdown -55.48% (-55.19%)
As you can see, the strategy is nearly identical to a buy-and-hold approach on a risk-adjusted basis. It is invested for only half of the time and also gains slightly over half of what buy and hold does. Furthermore, the maximum drawdown is consistent in both situations.
Vortex indicator trading strategy – conclusion
To sum up, today we showed you what the Vortex indicator is and how to calculate it. Moreover, we backtested a trading strategy that proved to perform similarly to buy and hold. However, we believe that with the addition of other indicators to the system, this strategy can perform much better.