Trend-Spotting with the Aroon Indicator

03/07/2013 9:00 am EST

Focus: FOREX

Market turns after an extended trend can be difficult to identify, says Walker England of DailyFX.com, but you can learn to spot market direction using the Aroon indicator.

Knowing when a trend has run its course can be a difficult task for forex traders. However, this information can be vital as traders need to decide how to manage existing positions or even open new trades with the trend.

A great example of this is displayed below on the EUR/JPY daily chart. We can see price advancing 2739 pips, but then sharply declining. Which begs the question, has the trend turned? To find out, today we will review the Aroon indicator.

EUR/JPY Daily Trend

chart
Created using FXCM’s Marketscope 2.0 charts
Click to Enlarge

The Aroon Indicator
The Aroon indicator was specifically designed to help traders find the trend and spot potential reversals. The indicator itself is derived from two lines, Aroon Up and Aroon Down. Both lines run in a defined range between 0-100, to help derive a currency pair’s strength or weakness.

As seen below, Aroon Down is depicted as a green line and as its name suggests helps track price in a downtrend. Aroon Up is depicted as a red line and measures the strength of an uptrend. Traders will watch both lines as they oscillate between 0-100 and change their market preference as one line crosses above the other. If Aroon Down is above Aroon Up, the trend is considered down with price expected to go lower. The opposite holds true if Aroon Up is residing above Aroon down. So how does this apply to our EUR/JPY example?

Below, we can again see our EUR/JPY daily trend, but this time we have added the Aroon indicator. Even though the pair has declined over the past two weeks, the Aroon Up line still resides above the Aroon Down line. Knowing this, trend traders can look for a price bounce as the trend is expected to continue. Even though Aroon Up is currently prominent, this can be subject to change. This analysis would be completely invalidated if price continues to fall, driving the Aroon Down line over Aroon Up.

EUR/JPY with Aroon

chart
Created using FXCM’s Marketscope 2.0 charts
Click to Enlarge

Based off of our Aroon analysis, my preference is to look for the EUR/JPY up trend to continue. One way to trade this retracement is to enter on a market swing or even a breakout to higher highs. Regardless of the strategy taken, traders should keep an eye on the Aroon indicator. If the Aroon Down crosses over the Aroon Up, this may signal an end to the EUR/JPY up trend and a change to market direction.

By Walker England, Trading Instructor, DailyFX.com

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