In the January 2010 edition of the journal Technical Analysis of Stocks and Commodities, Swiss market experts Etienne Botes and Douglas Siepman invented the vortex indicator (VI). Since then, this technical instrument has acquired popularity as a trustworthy trend tracking indicator capable of producing unexpectedly precise buy and sell recommendations.
However, more market testing and experience may be required to adequately assess the vortex indicator’s potential. In this section, we will look more closely at the vortex trading tactics.
- Using a pair of oscillating lines, the vortex indicator may detect trend reversals and validate present trends.
- The vortex was initially suggested in 2010, building on the work of well-known market expert J. Welles Wilder.
- The vortex indicator works best when combined with other indicators to identify trends and patterns and to support reversal signals.
What is the Vortex Indicator?
The vortex indicator uses two oscillating lines to detect positive trend movement and negative price movement. Crosses between the lines provide buy and sell signals meant to catch the most dramatic trending behavior, either upward or down. The indicator has no neutral setting and will always produce a bullish or bearish bias. The entire vortex indicator calculations may be found here.
The highs and lows of the previous two days or periods are used to build the indicator. Positive trend movement is shown by the distance between the current high and the previous low, while negative trend movement is indicated by the distance between the current low and the prior high. Strongly positive or negative trend movements will result in a wider distance between the two figures, whilst weakly positive or negative trend movements would result in a lesser distance.
Readings are typically taken over 14 consecutive intervals (but the technician may choose any duration) and then corrected using J. Welles Wilder’s actual range. Crossovers are compared to other trend-following indicators to provide legitimate trading signals, which are shown as continuous lines underneath price bars. Traders may utilize the vortex indicator as a solo signal generator, but bear in mind that in crowded or mixed markets, it is susceptible to strong whipsaws and false signals.
Synergy With Other Indicators
When the vortex indicator is set to longer periods, it reduces the frequency of whipsaws but produces delayed positive or negative crossovers. Shortening the duration, on the other hand, will result in several crossings that fail to create meaningful trend movement. High beta assets will generally react better to shorter-term settings, whereas slow-moving securities will respond better to longer-term settings.
By comparing vortex indicator signals to other trend-following tools, you may increase indicator reliability. The underlying mathematics is quite similar to Wilder’s average directional index (ADX), negativedirectional indicator (-DI), and positivedirectional indicator (+DI).
These calculations result in three lines that set off complicated crossings. Unlike the vortex indicator, Wilder’s approach may provide neutral signals that advise traders to hold or avoid risk.
Moving average convergence divergence (MACD) analysis fits the vortex indicator perfectly. Its three moving averages structure reduces misleading readings caused by several indicators that collect the same incorrect data. When plotted with histograms, the indication produces remarkably few false signals, making it an ideal companion for the noisier and more prone to whipsawing vortex indicator.
Before committing money, synergistic trading techniques use a simple approach that searches for sympathetic buy or sell signals in the vortex indicators as well as other indicators. The issue comes in two forms: first, considerable variances in data sources must exist to prevent reproducing incorrect information, and second, indicator periods must be experimented with and fine-tuned to concentrate on the targeted holding period, whether short, intermediate, or long term.
This last stage of fine-tuning indicator periods is critical since trends demonstrate time frame independence, enabling several uptrends and downtrends to emerge in various time segments on the same asset. This fractal tendency will result in erroneous readings if the vortex indicator is looking at one section of trend activity while another indicator is looking at another. Traders may avoid this problem by observing how indicator pairings interact on different instruments and in different time periods. It’s frequently advisable to leave MACD settings alone and alter vortex indicator periods instead.
A Vortex Indicator Trading Strategy
Authors Botes and Siepman proposed a vortex indicator trading method meant to filter out and reduce misleading signals in their 2010 work that debuted the vortex indicator. The day of the bullish or bearish crossing, the extreme high or low becomes the desired entry price, long or short. Those levels may not be reached on the day of the signal, resulting in a good-until-canceled buy or sell order that stays in place for numerous sessions, if necessary.
The extreme high or low becomes the halt and reverse action level if it is positioned at the moment of the crossing. When the price returns to the extreme high after a positive crossover, a short sell is covered and reversed to the long side, whereas a long position is sold and turned into a short sale once the price returns to the extreme low following a negative crossing.
They also advise integrating these entry filters with additional risk management strategies like as trailing and profit protection stops. These safeguards reduce the occurrence of false signals while increasing profit on the underlying trend, even if it fails to gain considerable pace. This method, however, fails to account for period duration, which may cause waves of false signals unless the holding period is changed and rigorously backtested.
Example 1: Microsoft
Let’s put the vortex indicator to the test using historical data from Microsoft Corporation (MSFT). In March 2014, Microsoft shares relaxed into a tight range, as seen in the graph below. This urged traders to keep an eye out for a successful breakthrough.
On March 14, there was a buy signal based on the vortex indicator, but the price finished significantly below the extreme intraday high of $38.13 per share. A trader would place a good-until-canceled (GTC) purchase order, which would be executed if the security returned to the trigger price.
Image by Sabrina Jiang © Investopedia2021
The price did rebound with excellent timing on March 17, crossing over the breakthrough and soaring into the lower $40s. On April 10, the signal shifted to the sell side, allowing for a successful exit but missing out on a significant portion of the rise.
Trade management is aided by MACD and a trailing stop. and advised taking a long trade one day after the vortex indicator buy signal. They had also sent a sell signal four days before, indicating a more lucrative exit. Meanwhile, a trailing stop at the March 31 breakthrough line at $41 per share would have triggered when the security dropped down on April 4, collecting a larger portion of the four-point rise.
Vortex Indicator and Price Patterns
When used with standard price pattern research, the vortex indicator may identify true trends while filtering out whipsaws and other range-bound mechanisms. This combination, in theory, should provide the most dependable buy and sell signals at two inflection points:
- When a well-developed trading range is about to break up or out.
- When a moving market loses momentum or encounters a big barrier, it encourages the entry into a new trading range.
This strategy benefits from the library of well-known range-bound patterns, such as flags, rectangles, and triangles, since natural breakout and breakdown levels have been extensively dissected, enabling the trader to concentrate on the vortex indicator while price tries support or resistance. Trend strength and persistence for cycle convergence may be assessed further using stochastics set at 5,3,3 or another relative strength indicator.
Example 2: American Airlines
Image by Sabrina Jiang © Investopedia2021
Between December 2014 and May 2015, American Airlines Group Inc. (AAL) formed a typical double top pattern before collapsing in a major decline. Eight sessions before the technical collapse, the vortex indicator sends a sell short signal, promoting early short sales inside the trading range. The crossover is also useful as an additional indication for pattern traders wanting to improve their chances.
Six weeks later, a vortex indication cover short signal occurred, setting up a winning exit around $40 per share.
The Bottom Line
J. Welles Wilder, the author of numerous major technical indicators, is prominently cited in the vortex indicator. The vortex indicator is based on a system for detecting fresh and accelerated uptrends and downtrends. The vortex indicator, like Wilder’s indicators, performs best when paired with other trend-following systems and conventional price pattern analysis.
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