Trading strategy: Divergence Aroon-Market

Description

Divergences are an interesting area in technical analysis. Divergences appear when the market price moves in one direction but the indicators point in the opposite direction. At that point in time the market movement is not in accordance with the underlying forces.

In the case of a significant divergence a market might run out of steam and change direction. A divergence signal is therefore a contrarian or anti-cyclical signal. Indicators that oscillate around a zero line as well as indicators based on moving averages can be used for detecting divergences. This strategy, proposed by German trading author Claus Grube, however, makes use of a special indicator, the Aroon Oscillator.

The strategy in detail

The strategy uses the following building blocks:
Aroon Indicator
Aroon Oscillator
Aroon Oscillator Divergence

The Aroon indicator - Aroon means "Morning dawn" in Sanskrit - was published by Tushar Chande in 1995. It is a very well designed indicator that indicates the amount of time that has passed since the period's high or low has occurred. Tushar Chande is a well known scientist, market analyst, and author of several trading books including "Beyond Technical Analysis". He has developed a variety of intelligent indicators. The Aroon Indicator consists of AroonUp and AroonDown. How both are calculated can be found on numerous web sites. It is less relevant in the framework of this divergence strategy. It is suffices to say  that when AroonDown is high the low market price has happened recently and when AroonUp is low the high market price has happened a while ago.

This screenshot shows AroonUp and AroonDown on a 15-minute Eurostoxx 50 market index chart.

The Aroon Oscillator is a line which oscillates around a zero line. It is derived by subtracting AroonDown from AroonUp. When AroonDown is high (the low has happened recently) and AroonUp is low (the high has happened a while ago) we get, for example, a result below zero.

In this screenshot the Aroon Oscillator is currently low. This means a low has happened recently and a high has happened a longer time ago.

The Aroon Oscillator Divergence detects whether the Aroon has run in the same direction as the market price recently. When it has run differently, we have a divergence! When there is no market trend or the Aroon runs parallel to the market its value is around 50. At 75 there is a divergence with the Aroon Oscillator rising and the market falling. At 25 there is also a divergence with the Aroon Oscillator falling and the market rising.

When to open a position?

Aroon Oscillator Divergence = 50. No trading signal. Market and indicators are in sync.
Aroon Oscillator Divergence = 75. Buy signal. Market down but indicator up.
Aroon Oscillator Divergence = 25. Short sell signal. Market up but indicator down.

In this screenshot we see the market price. Below the market the Aroon Oscillator Divergence is shown. The current value is 50 which implies that there is no divergence between market and indicator.

On 29 October at around 16h00, for example, the Aroon Oscillator Divergence is at 25. This indicates a divergence. The market is rising (or rather, the market price is above the price from one day ago) but Aroon Oscillator is below the value of the day before. This could result in a trend change as the market rise is not supported by the indicator.

When to close a position?

In this basic version of the strategy there is always an open position, either long or short. So a position is closed when the next signal appears. The basic strategy with these parameters produces a signal every day or every other day. It runs nicely with the market flow. These parameters are calculated on a 1-day Aroon (56 quarters of an hour) in the Eurostoxx 15-minute chart. The first look back point is a day back, the second is two days back.

In this screenshot a first divergence occurs on 31 March. The market is falling but the Aroon Oscillator is rising. Hence the divergence is at 75. This is a buy signal. On 6 April, however, the opposite divergence, 25, occurs. The market is rising but the Aroon Oscillator is falling. The long position is closed and a short position is opened.

This screenshot shows the result of the strategy applied on the Eurostoxx 50 market index since 2006. The result is astonishingly good. Note, however, that the bulk of the profit was realized between late 2007 and early 2009. Outside this period results are less impressive. This illustrates that strategies do not work efficiently all the time. Strategies need frequent adapting to market circumstances (changes in volatility, volume, speed...). Hence it is important to experiment and adapt a strategy and its parameters.

Adding filters and stops

Results may be enhanced or smoothened with trend and/or volatility filters. Profit-targets and stops may be used as well.

In this screenshot a special trend filter* based on an MACD concept and a trailing stop of 200 points on the Eurostoxx 50 have been added. As a result the equity curve has less overall profit but benefits from smaller draw downs. The hit ratio is a respectable 66,6% with an average of one trade per week.

 

 

 

 

* See trading strategy TrendPlus for details on this trend filter.

Conclusion

The impression is that Claus Grube’s strategy, like so many others, seems to work best in times of strong trend and high volatility. For situations with low volatility, such as after October 2008, Grube proposes adaptions as well as shortening the period length on which the Aroon is calculated and reducing the look-back periods. Divergence is definitely an interesting concept in trading worth exploring. The Aroon-Market Divergence strategy is one way to do this.

Practical implementation

In NanoTrader Full follow these steps:

• Choose the instrument you wish to trade.
• Change the time frame to 1 week if you prefer it to 1 day.
• Semi-automated trading? Simply activate the TradeGuard+AutoOrder or the AutoOrder function.