Aroon indicator is developed by Tushar Chande in 1995. Aroon is an indicator system that determines whether a stock is trending or not and how strong the trend is. 'Aroon' means Dawn's Early Light in Sanskrit, Tushar chose this name as the indicators are designed to reveal the beginning of a new trend.
Aroon indicator is similar to other momentum oscillators in terms of being used to time the market entry into a trend. It becomes most effective when confirming signals or conditions identified by additional technical analysis.Figure .1.Illustration of Aroon Indicator
Construction of Aroon Indicator
Understanding the underlying formula used for the construction of Aroon helps traders to take a prudent decision while trading complex scenarios. The Aroon indicators fluctuate between 0 and 100. Aroon-Up is based on price highs, while Aroon-Down is based on price lows. The default parameter is considered as 25. Aroon indicator is calculated using the following formula:Figure .2.Aroon Indicator Formula
In simple language, the indicator consists of the "Aroon up" line, which measures the strength of the uptrend, and the "Aroon down" line, which measures the strength of the downtrend.
Working of Aroon
—Like the most momentum oscillators, the Aroon appears on a chart in a separate window below the price chart. The Aroon is plotted against a middle line of 50 that differentiates strength of the trend.
—Aroon-Up and Aroon-Down are complementary indicators that measure the elapsed time between new 25-day highs and lows, respectively.
—They are shown together so chartists can easily identify the stronger of the two and determine the trend bias.
—The Aroon Up and the Aroon Down lines fluctuate between zero and 100, with values close to 100 indicating a strong trend and values near zero indicating a weak trend.
—The lower the Aroon Up, the weaker the uptrend and the stronger the downtrend, and vice versa.Figure .3.Aroon Oscillator
—The main assumption underlying this indicator is that a stock's price will close regularly at new highs during an uptrend, and regularly make new lows in a downtrend.
—The indicator focuses on the last 25 periods but is scaled to zero and 100. Therefore, an Aroon Up reading above 50 means the price made a new high within the last 12.5 periods. A reading near 100 means a high was seen very recently.
—The same concepts apply to the Down Aroon. When it is above 50, a low was witnessed within the 12.5 periods. A Down reading near 100 means a low was seen very recently.
Usage of Trend lines and Moving Average is the most effective way while trading with Aroon Indicator. Moving Average and Aroon together are used to develop a trading strategy. Key points about it are discussed below-Figure .4.Aroon Indicator & SMA Buy & Sell Signals
—Aroon-up is greater than Aroon-down
—Aroon-up is greater than 50
—Buy signal is generated after a close above 20 DMA as indicated
—One can use multiple ways to book profit & exit, like Aroon-Up again near 100 or price trend line breakdown or a close below 20 SMA.
—Aroon-Down is greater than Aroon-Up
—Aroon-Down is greater than 50
—Sell signal is generated after a close below 20 DMA as indicated
—One can use multiple ways to book profit & exit, like Aroon-Down again near 100 or price trend line breakdown or a close above 20 SMA.
Consolidation and Aroon
When both indicators are below 50 or both are moving lower with parallel lines, it can signal that the price is consolidating. New highs or lows are not being created. Traders can watch for breakouts as well as the next Aroon crossover to signal which direction price is going.
For 25-day Aroon, readings below 50 mean a 25-day high or low has not been recorded in 13 or more days. Prices are clearly flat when not recording new highs or new lows. Similarly, consolidation is usually forming when both Aroon-Up and Aroon-Down move lower in a parallel fashion and the distance between the two lines is quite small. This narrow parallel decline indicates that some sort of trading range is forming. The first Aroon indicator to break above 50 and hit 100 will trigger the next signal.Figure .5.Aroon Indicator & Consolidations
The interesting aspect of using the Aroon indicator in day trading is that you can also use it during range-bound markets. When the price of a security consolidates within a range, the Aroon Up and Aroon Down lines will stay parallel to each other.
—Chartists can use the Aroon indicators to determine if a security is trending or trading and then use other indicators or technique to generate appropriate signals.
—Aroon indicators are quite different from typical momentum oscillators, which focus on price relative to time.
—A surge in Aroon-Up combined with a decline in Aroon-Down signals the emergence of an uptrend.
—A surge in Aroon-Down combined with a decline in Aroon-Up signals the start of a downtrend.
—A consolidation is present when both move lower in parallel fashion or when both remain at low levels (below 50).
(The author is Head - Technical & Derivative Research at Narnolia Financial Advisors Ltd.)
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