It is not that unusual that a lot of the names given to technical indicators sound rather exotic. This is certainly the case with this indicator which was designed by Tushar Chande in 1995. Chande is a technical analyst with more than 25 years of experience, he is the creator of many widespread and popular technical indicators such as this Aroon indicator. But also the Stoch RSI, for example, was developed by him.
The name of the indicator literally refers to "the dawn's early light" in Sanskrit. The connection with the world of technical analysis is quickly made. The dawn is a reference to 'the new trend' and with the early light there is a reference to the ability of the indicator to make that new trend visible at an 'early stage'.
The indicator actually consists of two separate indicators. There is the Aroon-up and the Aroon-down line.
Where 25 is the default value of the indicator parameter and 'period' is the timeframe used. On a daily chart this reads as "days since the 25 day high".
All values are calculated as a percentage value indicating the time since the previous high within the specified period (default '25').
It is important to remember that in a daily chart - where each period represents exactly 1 day - the value '50' will never be visible because this value corresponds to 12,5 days. The closest possible number less than 50 is 48 (13 days) and the closest possible value higher than 50 is 52 (12 days).
What is striking about this indicator is that it differs greatly from other momentum oscillators because this indicator focuses primarily on time. Indeed, the indicator changes as the time between a new high or low increases. The indicator is used to discover and anticipate new potential trends early on, identify sideways markets but also to visualize correction periods within existing trends. It is a very versatile indicator but it takes some practice to learn to interpret it correctly.
The most basic application is the location of the Aroon-up and Aroon-down in relation to the 50-level, this tells us something about the existing trend. This is considered positive if the Aroon-up is above 50 and Aroon-down is below 50 at the same time. Buyers are in favor. However, if the Aroon-up quotes below 50 and the Aroon-down quotes above 50 then the reverse is true. In that case it is the most recent lows that lie in the last half of the pre-specified period. Sellers are in the lead.
In order to detect possible new trends early, the progression of Aroon-up and Aroon-down is examined. The first important signal occurs when the Aroon-up moves above the Aroon-down, which means that new highs occur more recently than new lows.
This is followed by an initial confirmation when the Aroon-up is above 50 and the Aroon-down is below it.
Lastly, there is the final confirmation at the time when the Aroon-up reaches the value of 100 while the Aroon-down continues to quote low.
The progression is exactly the same as for a new uptrend except that now it is the Aroon-down that is rising above the Aroon-up. New lows are more recent than new highs.
This is followed by an initial confirmation when the Aroon-down is above 50 and the Aroon-up is below.
Lastly, there is the final confirmation at the time when the Aroon-down reaches the value of 100 while the Aroon-up continues to quote low.
Keep in mind that the order of the signals does not have to follow this exact sequence. In the chart below, for example, you can see that the Aroon-down first rises above the 50 level and only afterwards crosses the Aroon-up.
Continued values of both the Aroon-up and Aroon-down below the 50-level are an indication that the market is moving sideways. Indeed, this implies that neither new highs nor lows were identified in the last half of the pre-specified period.
Another way that consolidating markets can be recognized is if both the Aroon-up and Aroon-down move down simultaneously and parallel to each other. This means that the time interval to both the most recent high and low increases simultaneously. This can only mean that the price is moving rather sideways.
The Aroon indicator is a versatile indicator that is quite unique as it focuses primarily on the elapsed time and compares it to the evolution of the stock price.
In the next article, I'll continue with the screen capabilities of this indicator in our stock screener and show you how this indicator is best used to help identify potential trading setups.
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