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 IndicatorUnderstanding 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.
—They are shown together so chartists can easily identify the stronger of the two and determine the trend bias.
Figure .3.Aroon Oscillator
—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.
Trading Technique: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
—Buy signal is generated after a close above 20 DMA as indicatedExit
—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.
—Sell signal is generated after a close below 20 DMA as indicatedExit
—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.
Conclusion—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.
—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.)Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.