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To reduce losses during consolidation periods, it is important to use a tool for filtering trend direction in a trading strategy. One such technical indicator is the Choppiness Index created by E.W. Dreiss. The Choppiness Index indicator is is an indicator designed to determine if the market is either choppy (trading sideways) or not choppy (trading within a clear trend either up or down).
What is the Choppiness Index indicator?
The purpose of ChoppinessIindex is to determine price volatility, and the algorithm is based on accounting for the trading volume. To effectively use this tool in your trading, it is recommended that you carefully study the rules for its use and technical analysis whilst also putting it into practice on a demo trading account.
The choppiness index indicator is not one of the standard analytical tools. It will need to be downloaded and integrated into your trading platform. For this, the file with the indicator would usually be copied to the root folder “indicators” of the trading platform (if using MetaTrader). The choppiness Index will then be available in the custom indicators tab.
When transferring to the price chart, you do not need to make changes to the standard parameters but feel free to experiment with settings if you would like to adapt it to your own trading strategy.
It is permissible to make adjustments to the additional parameters like thickness and color of the curve line, setting additional levels. Such changes do not affect the indicator operation algorithm. On a chart, the choppiness index will look something like this:
The algorithm of the choppiness index is based on trading volumes. The tendency of the indicator curve to maximum values indicates an increase in the activity of large market participants, and to a low for its absence.
For the effective use of this indicator, it is important to understand that the movement of the line in an additional window does not depend on fluctuations in the price chart.
As mentioned earlier, it is advisable to use this analytical tool to identify consolidation, that is, the lack of activity of large market participants. Such periods are characterized by lateral movement of the chart in a narrow range.
How to use the Choppiness Index indicator?
As practice shows, during consolidation periods, a large majority of technical indicators display false signals for opening positions, thus if using a trend trading strategy, I would refrain from short-term trading during market consolidation. If the line in the additional indicator window touches its minimum, then this indicates a lack of trading activity. Striving for the maximum indicates the beginning of a trend or correction. It is important to remember that the indicator does not reflect the potential direction of a financial instrument’s value, but only its intensity. Because of this, the Choppiness Index is primarily used in its trading solely as an auxiliary tool.
The indicator can take values between “0” and “100”. High indicator values in the Choppiness Index show trendless phases in the market. Low indicator values indicate trending conditions. The lower the value of the Choppiness Index, the more pronounced the trend is thought to be.
Choppiness Index trading strategy
In this example, we will use the Choppiness Index indicator solely for finding trend based trade entries. This strategy is very simple and can be easily adopted by forex traders of all levels.
Choppiness Index Buy Signal
- The market should be trending.
- The market should be bouncing out of the latest support.
- Yellow line from the choppiness index should be rising from the lower band.
- We could enter a long position if the above conditions are met.
- We could place the stop loss below the last support.
- Take your profit could be if the yellow oscillator violates below the lower band.
Choppiness Index Sell Signal
- The market is likely to be trending down.
- The markets should drop out of the current resistance.
- Yellow oscillator from the choppiness index indicator should be falling from the upper band.
- We could place a short position if the above conditions are met.
- We could place a stop loss above the last swing high.
- Take profit could be if the yellow oscillator violates below the lower band.
Choppiness Index conclusion
There are many trend indicators in the market but the Choppiness Index indicator is a unique tool that can also help you to identify the consolidation phase in addition to the trend. However, it is also very important to consider the support and resistance zones when trading with any strategy.
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