Understand Vortex Indicator Trading Strategies

Swiss market technicians Etienne Botes and Douglas Siepman introduced the vortex indicator (VI) in the January 2010 issue of Technical Analysis of Stocks and Commodities magazine. Since then, this technical tool has gained traction as a reliable trend following indicator that can produce surprisingly accurate buy and sell signals.

However, it may take a few more years of market testing and experience to fully evaluate the vortex indicator’s potential. Here we take a closer look at the vortex trading strategies.

What is the Vortex Indicator?

The vortex indicator plots two oscillating lines: one to identify positive trend movement and the other to identify negative price movement. Crossings between the lines trigger buy and sell signals designed to capture the most dynamic trend action, higher or lower. There is no neutral setting for the indicator, which will always generate a bullish or bearish bias. You can find the full vortex indicator calculations here.

Indicator construction revolves around the highs and lows of the last two days or periods. The distance from the current high to the previous low indicates positive trend movement, while the distance between the current low and the previous high indicates negative trend movement. Strong positive or negative trend moves will show a longer length between the two numbers, while weaker positive or negative trend moves will show a shorter length.

Readings are usually captured over 14 consecutive periods (although the technician can choose any length) and then adjusted using J. Welles Wilder’s true range. Results are placed as continuous lines below price bars, while crossovers are compared to other trend-following indicators to produce valid trading signals. Traders can use the vortex indicator as a standalone signal generator, but keep in mind that it is vulnerable to significant sweeps and false signals in congested or mixed markets.

Synergy with other indicators

Adjusting the vortex indicator for longer periods will lower the frequency of sweeps but generate delayed positive or negative crossovers. On the other hand, shortening the length will trigger many crossovers that do not generate significant trend movement. As a general rule, high-beta bonds will respond better to shorter-term settings, while slow-moving securities will respond better to longer-term settings.

You can improve indicator reliability by comparing vortex indicator signals with other trend-following tools. The underlying math shows many similarities to Wilder’s Average Directional Indicator (ADX), the Negative Directional Indicator (-DI) and the Positive Directional Indicator (+DI).

Those calculations translate into three lines that cause complex crossovers. Unlike the vortex indicator, Wilder’s system can issue neutral readings that tell traders to stand or avoid exposure.

Moving average convergence divergence (MACD) analysis provides a perfect match with the vortex indicator. Its construction with three moving averages reduces false readings caused by multiple indicators capturing the same flawed data. When plotted with histograms, the indicator generates surprisingly few false signals, making it a perfect partner to the noisier and whipsaw-prone vortex indicator.

Synergistic trading strategies use a simple process that looks for sympathetic buy or sell signals in the vortex indicators as well as in other indicators before committing capital. The challenge comes in two forms: First, there must be significant differences in data sources to avoid replicating flawed information, and second, indicator periods must be experimental and fine-tuned to focus on the intended holding period, whether short, intermediate, or long-term.

This final step of honing indicator periods is essential because trends exhibit timeframe independence, allowing multiple up and down trends in different time segments on the same security to develop. This fractal behavior will produce false readings if the vortex indicator looks at one segment of trend activity while a second indicator looks at a second segment. Traders can overcome this error through trial and error, by watching how indicator pairs interact on different instruments and in different time frames. With MACD in particular, it is often best to leave settings alone and adjust vortex indicator periods instead.

A Vortex Indicator Trading Strategy

In the 2010 article that introduced the vortex indicator, authors Botes and Siepman described a vortex indicator trading strategy designed to filter out and limit false signals. The extreme high or low on the day of the bullish or bearish crossover becomes the intended entry price, long or short. Those levels may not be hit on the day of the signal, prompting a good-to-cancel buy or sell order that remains in place for several sessions, if necessary.

If positioned at the time of the crossover, the extreme high or low becomes the stop and reverse action level. In this strategy, a short sale will be covered and reversed to the long side when the price returns to the extreme high after a positive crossover, while a long position will be sold and converted to a short sale after the price returns to the extreme low return. a negative crossover.

They also recommend combining these entry filters with other risk management techniques, including trailing and profit protection tops. These protective measures lower the incidence of false signals while maximizing profit on the underlying trend, even when it is not gaining significant momentum. However, this approach fails to handle period length, which will trigger waves of false signals until adjusted to the predetermined holding period and then thoroughly backtested.

Example 1: Microsoft

Let’s use historical data from Microsoft Corporation (MSFT) to test the vortex indicator. As you can see in the chart below, Microsoft stock eased into a tight range in March 2014. This encouraged traders to look for a profitable breakout.

Following the vortex indicator, there was a buy signal on March 14, but the price closed well below the extreme intraday high at $38.13 per share. A trader will place a good-to-cancel (GTC) buy order that will execute when the security returns to that trigger price.

On March 17, the price did bounce back with perfect timing, crossing the breakout and rising into the low $40s. The indicator crossed over to the sell side on April 10, enabling a profitable exit that missed a large chunk of upside.

MACD and a trailing stop help trade management and suggested that a long position be executed one day later than the buy signal of the vortex indicator. They also issued a sell signal four days earlier, supporting a more profitable exit. Meanwhile, a trailing stop placed at the March 31 breakout line near $41 per share would have triggered when the security sold off on April 4, capturing an even larger part of the four-point uptrend.

Vortex indicator and price patterns

The vortex indicator also works well when paired with classic price pattern analysis to recognize legitimate trends while filtering out sweeps and other range-bound mechanics. Theoretically, this combination should generate the most reliable buy and sell signals at two inflection points:

When a well developed trading range is set to break out or break down. When a trending market loses momentum or reaches a significant barrier that favors the transition to a new trading range.

The catalog of familiar range-bound patterns, including flags, rectangles and triangles, favors this approach because natural breakout and breakout levels are fully deconstructed, allowing the trader to focus on the vortex indicator at the same time price tests support or resistance. Trend strength and durability can be further gauged for cycle convergence using stochastic set to 5,3,3 or another relative strength indicator.

Example 2: American Airlines

American Airlines Group Inc. (AAL) carved out a classic double top pattern between December 2014 and May 2015 and then broke down in a significant downtrend. The vortex indicator issues a sell short signal eight sessions before the technical breakdown, encouraging early short selling within the trading range. The crossover also works well as a secondary indicator for pattern traders looking to stack the odds in their favor.

A short signal for vortex indicator arrived six weeks later and set up a profitable exit near $40 per share.

The Bottom Line

The vortex indicator draws heavily on the earlier work of J. Welles Wilder, the creator of several important technical indicators. The vortex indicator builds on a signaling mechanism for new and accelerated uptrends and downtrends. As with Wilder’s indicators, the vortex indicator works best when combined with other trend following systems and classic price pattern analysis.