Aroon Points The Way

AROON
The Aroon indicator, which was developed by former STOCKS & COMMODITIES contributor Tushar Chande, attempts to indicate when prices are changing from trending to trading or trading to trending, and also give some idea of the strength of the move. It does this by measuring the periods between price highs or price lows.

The indicator consists of two line studies (plots) labeled Aroon Up (AU) and Aroon Down (AD). These names have no significance concerning direction; they are merely the names given to the plots. AU may be down at zero, while AD may be up at 100. In fact, this situation is one of the conditions we look for in our analysis.

Interpretation of the two plots revolves around three conditions: the extremes at zero and 100, indicating strength or weakness of uptrends or downtrends; crossovers of the two plots, indicating a possible change in direction or a change from trending to trading; and parallel movement between AU and AD, indicating a period of consolidation.

AU at 100 indicates strength. AU remaining between 70 and 100 indicates an uptrend. AD at zero indicates weakness; AD remaining between zero and 30 indicates a downtrend. If both plots remain at extreme levels, a strong trend is indicated. If AU remains between 70 and 100 while AD remains between zero and 30, then a strong uptrend is indicated.

FIGURE 1: APPLYING AROON. From January 3, 2012, through April 10, 2012, AU remained between 100 and 65, while AD remained between zero and 35. AAPL increased from 409 to 644 (a new high). Other conditions to look for are the AU and AD crossovers as well as consolidations.

Another condition to look for is the crossover. On April 13, 2012, AD started up and crossed AU, which continued toward zero. Note that on the day AD started up, the stop and reverse (SAR) switched from long to short. On the day of the plot crossover, the directional movement index (DMI) plus also crossed down through DMI minus. Are we getting confirmation?

Another condition to look for is parallel movement between the two plots of AU and AD. The period from April 11, 2012, through May 10, 2012, is not exactly textbook consolidation. However, parallel movement is also interpreted as expecting further consolidation until a major change is indicated. The parallel movements that follow are accompanied by a trading range during that period.

• Aroon Up: (n - (periods since highest high in "n+1" periods)/n) x 100
• Aroon Down: (n - (periods since lowest low in "n+1" periods) /n) x 100

The daily chart of the Diamonds exchange traded fund (ETF) (DIA) in Figure 2 is another good example of how Aroon works. On December 20, 2011, we see the ETF coming out of consolidation. AD starts back down, and the next day, AU starts back up. This is followed by the AU and AD movement, with AU staying within a range of 65 to 100 and AD within zero to 35. Keep in mind that this is our configuration, indicating a strong uptrend that occurred between December 20, 2011, and March 16, 2012. Note that every down day in the uptrend is accompanied by a downward move in AU. You might think this is a sell signal (similar to the stochastic crossing down through 80).

FIGURE 2: AROON ON THE DIAMONDS. On December 20, 2011, we see DIA coming out of consolidation. AD starts back down, and the next day AU starts back up. This is followed by the familiar AU and AD movement, with AU staying within a range of 65 to 100 and AD staying within a range of zero to 35.

But your assumption would be incorrect. Thus, you would need to establish some trading signals that are applicable to your trading goals.

THE UPS AND DOWNS
For these two examples, I added the Aroon indicator to my default trading template. I used the parabolic indicator (SAR) and the DMI pair for confirmation. In these two cases, they did an excellent job. If you're intrigued enough to want to play with this indicator, you might do likewise and add it to your favorite template. Track some of your favorite stocks, the ups and downs of which you are familiar. Use your favorite indicators for confirmation.

Once you are satisfied that the Aroon can stand alone, delete your indicators and paper trade for a period using just the Aroon. The results, good or bad, should help you decide how well the Aroon works for you.