One of the primary goals of technical market analytics is to identify performance trends in individual securities or indexes. The goal is that buying and selling opportunities can be identified before they are realized, allowing the savvy investor to time the market effectively. The Aroon indicator, a lesser-known technical tool developed by Tushar Chande in 1995, is used to locate trends early and show the likelihood that the trend will reverse.
At first glance, the Aroon indicator resembles the directional movement index. It plots multiple lines on a chart with moving values between zero and 100, all below the actual price movements of a security that are normally presented in candlestick style. The two lines on the Aroon indicator are called the "Aroon Up" and "Aroon Down," and the relationship between these two establishes the foundation for any trading strategy built on the Aroon indicator.
The Aroon Up represents the market's upward momentum. Larger values indicate a stronger movement, while low values express very little upward movement. The Aroon Down is interpreted the same way, only it demonstrates the strength of a downward movement. By their very nature, Aroon Up and Aroon Down tend to have an inverse correlation.
Part of the strength of the Aroon indicator is its simplicity: When Aroon Down is trending higher than Aroon Up, the price of the stock is expected to lose value. The opposite is true when Aroon Up is trending higher than Aroon Down. You would look to establish bullish or bearish outlooks on stocks based on the patterned relationship between the two lines. You can apply long and short strategies whenever trends do present themselves, trading long when the Aroon Up has strong values (50+) and trading short when Aroon Down has strong values.
You can also turn the Aroon indicators into a technical oscillator. To do so, make the bullish indicator range from 100 to zero and the bearish indicator from zero to -100, and then solve for the difference between the two values. This allows you to distinguish between trending markets and range-bound markets, which present less opportunity than trending markets.
Once you learn to read the oscillator, establish some cut-off ranges. For example, any values between -30 and 30 are not likely to indicate strong trends (with a value of zero showing no trend whatsoever), and you should most likely avoid making moves on weak trending markets. Instead, aim for trends that are either bullish (greater than +50) or bearish (less than -50).
The Aroon indicator improves the efficiency of your trading decisions. Theoretically, you should be able to identify the opportunity cost of jumping into a trend too early or too late. The Aroon indicator can also help you understand when to look for alternative opportunities during sideways markets.