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Aroon and the Nasdaq Composite

01/16/01 02:51:36 PM
by Dennis D. Peterson

While most indicators measure the amount of price change over time, Aroon measures the amount of time since an event has occurred.

Security:   $compq
Position:   N/A

For a given period of time, how long has it been since a new high or low has occured? The Aroon indicator, created by Tushar S. Chande, can help answer the question. Obviously, if the equity is in an uptrend for the selected period, it is zero days since the newest high. If the equity is in a downtrend, the answer again is zero days since the newest low. This tells me if the equity is in a consolidation pattern.

Consolidation patterns are a key feature of price movement. They occur frequently, more so than patterns with higher reliability in predicting future events, such as head and shoulders. They are often the precursors to breakouts.

The formulas for Aroon are:

Aroon(up)= 100((period length - no. of days since high)/100) and

Aroon(down)=100((period length - no. of days since low)/100).

I have been using a downward price channel to track the Nasdaq composite, especially since the composite broke through its major support at 3500. The channel has worked well to predict resistance, with the Nasdaq composite retreating (falling) when the upper line is approached and gaining when the bottom support line is approached. I have been encouraged that others have come to the same conclusion, namely that the Nasdaq has been in a downward price channel. The channel, however, doesn't tell me when the Nasdaq is finally going to bottom out. There have been candidates for a selling climax, but nothing definitive.

Consolidation patterns, when they are defined as a sideways movement or a sideways price channel, are almost always continuation patterns. If prices are in a trend entering the consolidation pattern, they will continue the trend when exiting. They can be useful to find a bottom because there are some rough rules of thumb about the distance between consolidations (they are roughly equal) or the distance between the start of major trend change and a major consolidation (the trend is about halfway to reaching extreme). The irony of this effort is that if the Nasdaq forms another consolidation pattern around today's prices it does not bode well for longs. Shorts will be happy, though.

When I draw the downward price channel, the most valid pair of lines -- those touching the most highs or lows-- are drawn taking into account candidate consolidation 1 (red circle with a number 1 in the upper chart) in Figure 1. A line drawn from the peak on September 1, 2000, used as the start of an upper trendline, is not as valid as a line taking into account consolidation 1. In other words, trying to find the most valid trendlines gives me a clue that something happened between mid-October and mid-November that was not a downtrend.

Aroon provides a means to verify a consolidation pattern. Figure 1 shows three candidate consolidations numbered 1, 2, and 3. Aroon has identified number 1 as the strongest candidate (using a 20-day period). If in fact a consolidation pattern has occurred, then a rule of thumb would be to take the distance from the start of the downtrend to the midpoint of the consolidation pattern and use that as the halfway point for the downtrend, or at least to the next major consolidation. Using consolidation pattern number 1, the distance is obtained by taking the difference between 4248 and 3252. When this difference, 996, is subtracted from 3252 the answer is 2256. By coincidence, the low that we have seen so far is 2251.7. In retrospect, candidate consolidation 1 corresponds to an important Fibonacci retracement level at 50%, if in fact 2252 is the low. Moreover, the number of 52-week highs and lows show improvement at these lower levels. Visually, candidate 1 has some of the characteristics of consolidation, but what does Aroon indicate?

Figure 1: Nasdaq composite (top chart) versus 25-day period Aroon (second chart from bottom) and 20-day period Aroon (bottom chart).
Graphic provided by: MetaStock.
Graphic provided by: Data vendor: eSignal<.
The bottom two charts are for a 20-day period Aroon (bottom chart) and a 25-day Aroon (second chart from bottom). Aroon up is identified with a green line and Aroon down is identified with a red line. The key to reading Aroon charts is to look for Aroon's extreme highs and lows, and for parallel movement. Parallel movement occurs in the band shown in the second chart from the bottom and parallel downward. Both Aroon up and down need to move down for a consolidation. When a downtrend is in force, every day is lower and Aroon up is going to be zero (because in the last 20 or 25 days there was no new high). You can see from the beginning of September that both charts indicate a downtrend. At the same time that Aroon down rises up because every day represents a new low, Aroon up declines because the high is getting further and further away from the start of the period. Aroon up and down cross, confirming the trend.

What would you expect from a consolidation? If every day in a period was equal, then I would not see a new high or low. This would be the perfect consolidation. Neither Aroon up or down see a new high or low and they both go down in value. Hence, the ideal case for consolidation is for both Aroon up and down to move down in parallel.

What happens to Aroon if a normal, less-than-perfect, consolidation occurs? You would expect the number of days for a new high or low to be half of the period. That is, about halfway through the period of choice, you would expect the highs to reverse and the lows to reverse. First, look for Aroon up or Aroon down to move from their extremes. In mid-October Aroon down starts to move down from its extreme. But, Aroon up has to get off the dime and start moving up if this is a consolidation. During the 25-day period Aroon doesn't show the desired parallel downward movement, and only gets close in November. Clearly the length of the period is too long for what may be a short term consolidation, so I shortened the period by five days to a 20-day Aroon period. With a 20 day Aroon period the parallel movement from the beginning of November to mid-November is seen. Just for drill, I shortened the period to 10 days and the parallel down movement was very visible.

A ten-day consolidation period is so short that some could legitimately argue it was just a retracement. In any event, Aroon is a valuable tool for finding consolidations.

Dennis D. Peterson

Market index trading on a daily basis.

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