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The Aroon indicator is not as well known as some other indicators that have been around for a much longer time. However, the Aroon indicator can be used to deliver signals that can suggest where a consolidating market is about to head.
What is the Aroon Oscillator and How to Read it
The Aroon Oscillator was developed by Tushar Chande in 1995 and measures the time between highs and the time between lows. The concept underlying the indicator is that strong uptrends will create new highs on a regular basis and strong downtrends will regularly generate new lows.
The indicator is composed of an “Aroon up” line and an “Aroon down” line. These two lines oscillate between 0 and 100. The “Aroon up” measures the strength of the uptrend while the “Aroon down” line quantifies the strength of the downtrend. When the “Aroon up” line is above the “Aroon down” line, it is a bullish signal. When the “Aroon down” line is above the “Aroon up” line, it is a bearish signal.
Chande recommends using 25 periods of data with the Aroon Oscillator. Typically, 14 periods is the default parameter when using it on a trading platform.
A Highly Profitable Strategy Using the Aroon Oscillator
When the two lines of the Aroon indicator move lower in parallel and are both below 50, it is a sign that consolidation is taking place. That’s because no new highs or lows are being made during the period. When using 25 periods, a reading below 50 indicates that a new high has not been reached in at least 13 days. This consolidation zone can be confirmed simply by looking at the price chart and ensuring that price is moving in a sideways channel.
Normally when we see consolidation, we would wait for the price to break out and then enter the trade at that point. However, with the Aroon indicator, you can get a foretaste of a breakout happening when the “Aroon up” line or the “Aroon down” line shoot up to 100. This signals the end of the consolidation and the beginning of a new trend.
View the highlighted portion of the chart below. With a parameter of 25 periods for the Aroon indicator for Ashford Hospitality Trust (NYSE:AHT), we see the “Aroon up” and “Aroon down” lines both descending parallel to each other. The sideways movement of the price confirms the consolidation. When the green “Aroon up” line begins its ascent over and above the “Aroon down” line, that is a signal that the breakout is about to be on the upside. The stop loss should be placed below the sideways range that led to the breakout. The exit could be made on the first bearish candle or by setting a trailing stop order. These breakouts can appear suddenly and disappear just as quickly, so timing the exit for a long-term trade can be tricky.
Conclusion
The Aroon indicator is a powerful technical tool that can be used to help visualize the highs and lows that are occurring in a market. These highs and lows can be useful signals for figuring out which way a breakout is about to occur.
