What is Aroon and How to Trade it on the S&P 500

Last Updated on November 28, 2022 by Mark Ursell

Aroon – Dawn’s Early Light

The S&P 500 index is a great way to invest, trade and make money out of the stock market. In this article, I show a straightforward but powerful trading strategy that anyone can use. This strategy is easy to follow using futures, CFDs and spread betting.

This long-term trading strategy uses a great indicator to keep you on the right side of the primary trend. It is simple to use and trades both long and short

Could I just Buy and Hold?

Buy and hold can be a great strategy over the long term. Over time, stock market indices tend to rise through economic growth and inflation. However, buy and hold returns have varied considerably depending on when the buying took place.

The right time to buy and hold has usually been when market valuations are low. Historically, buying when valuations are high has shown lower returns than buying when valuations are low.

In addition, buy and hold misses out on the opportunity to make money trading short during a bear market.

An S&P 500 Index Trading Strategy

If you are looking to trade the S&P 500 profitably over the long term, the easiest way is to follow the dominant trend. The S&P 500 has tended to show strong trends, both to the upside and to the downside. By trading a long-short strategy, we can take advantage of bull markets and bear markets.

The challenge is finding a strategy that gets you into trends when they are beginning and keeps you in the trend for as long as it lasts.

The Aroon Indicator

One way to guarantee that you will never miss a big trend is to trade when the market breaks out from a previous range.

Aroon means “dawn’s early light” and it is a good description of an indicator that gets you in at the start of a new trend. Developed by Tushar Chande, it measures how long since price made a new high or low.

The chart below shows the Aroon indicator with a 25-period lookback.

The green line shows how long it has been since the last 25 period high. A value of 100 means that the current bar is at a 25 period high. A value of 0 means that it has been at least 25 days since the last high. The red line shows how long it has been since the previous 25 period low.

The Aroon measures breakouts in an oscillator form. It also allows us to consider breakouts to the upside and the downside separately. When the green line is above the red line, the market is relatively strong. When the red line is above the green line, the market is relatively weak.

If you want to learn how to calculate the Aroon indicator it comes with my eBook: 21 More Technical Indicators. The eBook comes with a free excel spreadsheet as well as lots of tips and ideas for trading using technical indicators and chart patterns.

The Trading Strategy

This strategy is long-term and uses the closing prices. The strategy takes a few minutes a day to check the latest indicator values. The strategy trades infrequently and so transaction costs are low.

The rules for the strategy are simple:

• Buy when close is above 200 EMA, and Aroon Long crosses above 30
• Sell when close is below 200 EMA, and Aroon Short crosses above 30
• Close Buy when Aroon Long crosses below 70
• Close Sell when Aroon Short crosses below 70

I have not used a stop-loss or profit target, but these values are adjustable in the spreadsheet model.

In the backtest model I use the ATR to measure volatility. When the markets are more volatile, I use a smaller position size to compensate. When the markets are quieter, I use a larger position size.

Results

Video

The accompanying YouTube video gives more information about the Aroon indicator and demonstrates the backtest spreadsheet used to calculate the results. I also demonstrate how increasing leverage can bring greater returns but also higher volatility.

Further Resources

Buy the Spreadsheet

Tradinformed spreadsheets are a way for anyone with some Excel skills to begin testing their strategies. They can be used for any market or timeframe and allow you to test all sorts of technical indicators.

If you are interested in using the spreadsheet that I used to carry out this backtest analysis have a look at the Tradinformed Backtest Models available now in the Tradinformed Shop.

Reading

Reading good trading books is the best way for new traders to learn and experienced traders to sharpen their skills. John F. Carter is the founder of TradetheMarkets.com and his book: Mastering the Trade, Second Edition: Proven Techniques for Profiting from Intraday and Swing Trading Setups, is a very readable and useful guide to trading the financial markets. It covers market behaviour, trader psychology and has lots of trading ideas and set-ups. I enjoyed the original 2005 edition of the book and would recommend that you check this book out.

More Trading Strategies

If you are interested in trading strategies for stocks, indices and forex check out the Trading Strategies page for lots more ideas.