Knowing when to enter the market is one ofthe most important skills in trading and investing.
Your aim is to hop into emerging trends asearly as possible in order to catch the maximum price swing and one of the best ways to dothis is by predicting potential trend inceptions on a chart.
One indicator that can help you do that isthe vortex indicator.
So today we’ll talk about a reliable trendfollowing tool, the vortex indicator and I’ll show you how to i use it when I’m tradingstocks.
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The vortex indicator (VI) is a relativelynew trend-following tool that you may have never heard of.
This indicator signals the formation of anew trend or the continuation of an existing trend, and it can be used across all financialmarkets, although i use it mainly for trading stocks.
The vortex indicator consists of two oscillatorsmeasuring upward and downward movement, its development being inspired by the naturalflow and vortexes of water that occur in rivers.
You can see a vortex pattern in your chartsby connecting the lows in the candles with the highs in the consecutive candles, andthen the highs with the consecutive lows.
The bigger the difference between the lowof a candle and the next candle's high, the stronger the upward vortex (VM+).
Likewise, the bigger the difference betweenthe high of a candle and the next candle's low, the stronger the downward vortex (VM-).
The vortex indicator includes two trend movementlines plotted in a separate window, called the +VI (positive trend movement) and the–VI (negative trend movement).
The positive trend movement, represents thedistance of the current period high from the previous period low.
And similarly, the negative trend movement, represents the distance of the current period low from the previous period high.
This indicator uses the average true rangein its calculation, meaning the current high, current low and prior close to measure volatility.
So basically, to keep it very simple, thevortex indicator normalizes the positive and negative trend movements by dividing themby the true range.
So, we could say that it shows volatility-adjustedpositive trend movement and volatility-adjusted negative trend movement.
Like most indicators the vortex one can beused in almost all time frames and is market-neutral.
However, you will have better results whenyou’ll use it on longer time-frames, such as daily charts, because the “price noise”in lower time frames will produce many false signals.
If you do use the vortex indicator on a veryshort time-frame, such as 5 minute chart, I suggest increasing the indicator’s value, from 14 the default settings to 21 or 30, to smooth out lateral price movements.
Now, how to trade with the vortex indicator.
The vortex indicator plots two oscillatinglines: one to identify positive trend movement and the other to identify negative price movement.
Crossovers between the lines trigger buy andsell signals that are designed to capture the most dynamic trending action, higher orlower.
So, the simplest signals the indicator generatesare crossovers between positive trend movement VM+ and the negative trend movement VM-.
When the positive vortex crosses above negativevortex the trend is up, and if negative vortex crosses above positive vortex the trend isdown.
The crossover strategy works perfectly whenthere's a clearly defined trend.
You can use the vortex indicator as a standalonesignal generator, but keep in mind that it is vulnerable to significant false signalsin congested or mixed markets.
So pay attention when the market is in a consolidationphase, because this system will generate false signals.
To diminish the occurrence of false signals, you could adjust the settings of the indicator.
Adjusting the vortex indicator to longer periodswill lower the frequency of false signals but will generate delayed entries.
On the other hand, shortening the period ofthis indicator will lead to many crossovers that fail to generate significant trend movement.
As a general rule, stocks with high volatilitywill respond better to shorter-term settings, while slow-moving stocks will respond betterto longer-term settings.
As with most indicators, the vortex one worksbetter when used with other studies and filters, like price action.
A first filter is adding a simple moving average(SMA) to the chart to act as a long-term trend filter.
You open long trades if the price is abovethe SMA and the +vi positive trend movement crosses above the –vi negative trend movement, signaling an active uptrend You open short trades if the price is belowthe SMA and -vi negative vortex line crosses above the +vi positive vortex line, signalingthat a downtrend is under way.
This way you will not open trades that goagainst the long term trend.
A 200-period SMA is a good long-term filter.
So here is a tesla daily chart since the beginningof 2019.
As the price stayed most of the year belowthe 200 ma, only short trades were available.
And here’s Walt Disney stock during thesame period.
During the first 3 months of the year we witnessa lot consolidation above the 200 ma, and the signals weren’t as accurate.
But since March 2019 we had 2 big buys, onehere, and another one here.
Another method to reduce false signals isto only place trades when either the positive trend movement VM+ or negative trend movementVM- are above the 1.
The two lines of the vortex indicator oscillateabove/below 1, and when there's a crossover it means that one of the lines goes above1 or is very close to it.
To increase your chances of trading when there'sa strong trend, you could wait for the positive line to go above 1.
1 for a long entry, andwait for the negative line to go below 0.
9 for a short entry.
Also, here’s another filter you could useto increase this indicator's effectiveness.
You take note of the candle where a crossoverbetween the positive vortex line VM+ and negative vortex line VM- occurred, and you place alimit order at the high or low of that candle.
So you don’t enter when the crossover occurs, you wait for the limit order to be filled.
This way, the high or low of the crossovercandle will become the entry price of the trade.
To make it very clear, instead of, for example, opening a long position when the positive vortex line VM+ crosses above the negativevortex line VM-, you'll place a conditional order 1 point above the high of the candlewhere the crossover happened.
Only if the prices goes above that candle'shigh, the order will be triggered.
As you can see in this example, there wasa bullish crossover, but the price never went above the high of the trigger candle, so thetrade was not opened.
For a short entry, you'll place a conditionalorder 1 point below the low of the candle where the crossover happened.
Only if the prices goes below that candle'slow, the order will be triggered.
If you pay attention at this chart, you canobserve a crossover here, but by using this filter, the trade never happened, as the pricewent the other way.
So, you could save a lot of bad entries ifyou follow this simple filter.
Here’s another important tip.
When you see multiple crossovers in a shortperiod of time, this is a sign of market indecision, with no clear direction.
It’s better to ignore the setup on thatstock and search or other opportunities.
Take a look at this example.
During February 4th to February 15th we hadmultiple crossovers.
That’s a lot of crossovers in a span of10 days.
When you see this pattern, it’s better toabandon the setup, because the likelihood of a false signal is pretty high.
Also, another clue is the distance betweenthe 2 lines of the vortex.
Look at the range during the analyzed period, it’s pretty tight, and that’s another sign of range bounding markets.
Now, the vortex indicator can be used acrossmultiple timeframes.
For example, you can apply it to weekly andmonthly charts to define the bigger trend and then apply it to the daily chart to generatesignals within that trend.
Using the daily chart, you could focus exclusivelyon bullish signals when vortex on the weekly chart indicates an uptrend and on bearishsignals when vortex on the weekly chart indicates a downtrend.
Also, you can use other indicators or priceaction in combination with the vortex indicator to confirm the existence of a trend.
The vortex indicator is far from being a perfectindicator and has its strengths and weaknesses, but when used correctly it could be a veryvaluable addition to your trading toolbox.
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Until next time.