Adaptive Price Zone Technical Indicator Explained

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Adaptive Price Zone Technical Indicator Explained

The adaptive pricing zone, or APZ, is a technical indicator created by Lee Leibfarth and originally published in the journal Technical Analysis of Stocks and Commodities (September 2006 issue: “Identify the Turning Point: Trading With an Adaptive Price Zone”).

The APZ is a volatility indicator that appears as a series of bands on a price chart. The APZ was designed to assist traders in identifying probable market turning moments in non-trending, turbulent markets. This article will look at the APZ computations as well as some of the potential trading applications.

Calculating the Adaptive Price Zone

The APZ is based on a short-term double-smoothed exponential moving average, or EMA, which responds to price movements fast and with little lag. To build a fast-reacting average, an EMA of another EMA is used. The most recent price data in a specific lookback time is given greater weight, or worth, by an EMA. This is in contrast to a simple moving average (SMA), which assigns equal weight to all data points in the lookback period. Because an EMA highlights recent price action, it can react to current price variations and changes in market circumstances more quickly. The closing prices of a five-period EMA and another five-period EMA are used by the APZ.

The APZ’s adaptive component stems from its use of an adaptive range to gauge volatility. This volatility number is calculated by subtracting the current high’s five-period EMA from the current low’s five-period EMA:

Volatility Value = Five-Period EMA of Five-Period EMA of (High – Low)

To construct the upper and lower bands, the volatility number is multiplied by a deviation factor (for example, a deviation factor of 2). The deviation factor influences how far the bands look from the average price; greater deviation factors encompass price more loosely, while lower deviation values follow price more closely. After multiplying the volatility value by a certain deviation factor, the volatility value is added to define the upper APZ band and deducted to produce the lower APZ band:

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Upper APZ Band = (Volatility Value * Deviation Factor) + Volatility Value

Lower APZ Band = (Volatility Value * Deviation Factor) – Volatility Value

How It Works

The APZ computations produce two bands that may be seen on a price chart. The top and lower APZ bands are neither symmetrical or consistent. The APZ bands, on the other hand, take volatility into account and alter in shape and breadth (distance from each other) when price activity changes. In general, the space between the upper and lower APZ bands widens with higher price fluctuations and narrows during times of minimal price movement. As a result, broad bands indicate more volatility, whereas tight bands indicate less volatility. Figure 1 is a daily chart of the e-mini Russell 2000 futures contract.

Figure 1: This daily chart of the e-mini Russell 2000 futures contract shows how the APZ bands react to changes in volatility.

Image by Sabrina Jiang © Investopedia2021

Price action is generally contained inside the APZ’s bands. Price has diverged from its statistical average when it passes above or below the bands, and price has a propensity to revert to the statistical average within the bands. With this in mind, the APZ may assist traders in identifying potential turning points: When price passes above the upper APZ band, there is a statistical pull for price to return back inside the APZ bands; when price crosses below the lower APZ band, there is a buying opportunity.

Trading Applications

The APZ indicator may be used to any market or chart period, but it is most helpful in choppy, non-trending markets. The most simple way to use the APZ is to initiate a short position (sell) when the price breaches the upper APZ band, and a long position (buy) when the price breaches the lower APZ band. Figure 2 is a one-minute chart of the Russell 2000 e-mini futures contract. The yellow highlighted regions indicate price crossings above or below the APZ bands. In certain cases, a little blue dot is affixed to the pricing bar where the infraction occurred.

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Figure 2: This one-minute chart of the e-mini Russell 2000 futures contract shows where price has violated the APZ bands, indicated here by the blue dots (with yellow highlights).

Image by Sabrina Jiang © Investopedia2021

While the APZ may be used to identify prospective buy and sell opportunities, its use as a stand-alone trading strategy is limited. Due to the asymmetry of the APZ bands, traders should utilize profit objectives and other money management measures to close a trading position. To put it another way, traders should not merely wait for an opposing signal before closing or changing a position.

A separate indication, like practically every other trading indicator, may be valuable for verifying a buy or sell signal. Because the APZ works well in bumpy markets, a trend-measuring indicator such as the Average Directional Index, or ADX, may be useful in determining the relative strength of a trend and so confirming or rejecting an APZ signal.

Welles Wilder’s ADX may assist traders identify places where a trend is losing strength and, as a result, validate where price reversals are likely to occur, as suggested by the APZ. The ADX indicates the relative strength of a trend and is often shown as a curved line underneath a price chart. ADX readings below 30 and falling indicate a weakening trend and may validate possibilities for expected price reversals indicated by the APZ. When ADX levels are over 30 or climbing, confirmation does not occur, and any APZ indications should be treated with care.

Figure 3 is a chart that includes both the APZ and ADX indicators. In this case, the ADX values stay over 30 in all occasions when the price has pierced the APZ bands. Because the ADX did not offer confirmation, these prospective entry signals may be disregarded.

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Figure 3: This 144-tick chart of the e-mini Russell 2000 futures contract shows the Adaptive Price Zone indicator used with the ADX for confirmation. In this case, higher ADX values indicate that the trend is still strong, and therefore, the APZ signals are not confirmed.

Image by Sabrina Jiang © Investopedia2021

The Bottom Line

The APZ technical indicator allows traders to identify impending market reversals. Because the APZ works best in choppy, non-trending markets, traders should use a trend-measuring indicator in addition to the APZ to avoid trade entry during times of significant trending market activity.

The APZ inputs may be adjusted to match the trading instrument, chart interval (such as daily or five-minute), and trading temperament. The deviation setting has the most influence on the indicator, with smaller values closely tracking price and bigger values allowing price to bounce between the upper and lower APZ bands.

Price bands are well-known technical indicators among traders. While comparable to other bands, the APZ technical indicator employs a quicker moving average calculation, allowing the APZ to react to price movements more swiftly, especially in turbulent, fast-moving markets.

Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money.

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