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Thursday, August 13, 2009

How to use the Aroon indicator and oscillator

With Independence Day around the corner, it may be an opportune time to look at a technical indicator, called Aroon. Tushar Chande has a PhD in Engineering and owns a financial services firm in Iowa, USA. An author of several books and holder of 9 US patents, he developed the Aroon indicator and oscillator back in 1995.

The Aroon indicator consists of two lines - the Aroon Up and the Aroon Down. They are calculated based on the highest high and the lowest low made by a stock or index in a given period. Their values range between 0 and 100.

Though the method of calculating the two lines are fairly straight forward, I haven't included the formulae (which tend to scare off maths-shy
investors). If you love crunching numbers, check up the www.investopedia.com site, or write to me.

A trend following indicator, Aroon tends to score where MACD or moving averages may prove inadequate. Crossovers between the Aroon Up and Aroon Down lines are indicative of changes in trend.

The Aroon oscillator has values of +100 and -100 at the extremes, oscillating around the '0' level. Those who are familiar with the RSI and Stochastic oscillators - discussed in earlier posts - may make the Aroon an additional arrow in their quiver.


The 1 year bar chart pattern of the BSE Sensex index above will help us to understand how the Aroon indicator and oscillator works

When the Aroon Up line (in green) is between 70 and 100 and the Aroon Down line (in blue) is between 0 and 30, the trend is strongly bullish (between mid-Mar '09 to mid-Jun '09). The opposite, that is the Down line on the top range and the Up line on the bottom range is strongly bearish (between mid-Sep '08 to end Oct '08).

Crossovers indicate trend change - up trend when the Up line crosses above the Down line, and down trend when the Down line crosses above the Up line. Note that between Nov '08 and Feb '09, there were several crossovers while the Sensex consolidated sideways. Similar is the case between mid-Jun and mid-Aug '09.

The confusion created by frequent crossovers during consolidation periods can be alleviated to an extent by using the Aroon oscillator, which plots the difference between the Aroon Up and Aroon Down lines. The '0' level decides the trend. The farther away from the '0' line, the stronger the trend.

As with other technical indicators, applying the Aroon indicator and oscillator in actual investing requires experience and practice. Using it together with other indicators and oscillators is recommended, because technical analysis is not foolproof.

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