Traders have been searching for reliable trend reversal indicators for as long as technical analysis has been around. While the directional movement index (DMI) predicts trend direction or significant price moves, the vortex indicator incorporates the concept of flow and vortex motions in the market to yield a more accurate prediction.
Let’s take a closer look at the vortex indicator and how you can use it to predict trend reversals.
What is the Vortex Indicator?
The vortex indicator was developed by Etienne Botes and Douglas Siepman and published in Technical Analysis of Stocks & Commodities. In essence, the vortex indicator uses the same concepts as the direction movement index (DMI) with the exception of calculating values for inside bars rather than assuming that there was no directional movement.
The authors drew inspiration from Austrian forester, experimenter, and inventor, Viktor Schauberger, who studied the fluidic vortexes of water in rivers and streams. With these concepts in mind, the authors came up with the idea that these vortex motions mimic those of the markets and attempted to translate the idea into a technical indicator.
With the success of other nature-inspired indicators, such as Fibonacci retracements and Elliott waves, traders may want to take a closer look at the vortex indicator as a way to more accurately predict trend reversals. The indicator may deserve special attention given that it’s not widely used (yet) and could provide an edge in the market.
Trading with the Vortex Indicator
The vortex indicator is composed of two lines, VI+ and VI-, that represent upward and downward movements and are plotted on a sub-chart above or below the price chart. When VI+ is larger, the market is trending higher, and when VI- is larger, the market is trending lower. Of course, the crossovers represent potential trend change events.
The vortex indicator’s authors recommend an entry position on the point or day of a crossover. If you have an existing position, the authors recommend closing it upon the opposite crossover. A trailing stop based on technical indicators like the average true range (ATR) is also recommended to let profits run and limit losses in the event of a quick reversal.
In the example above, the VI+ crossed above the VI- on August 21 and remained above it until September 3. Traders that took a long position upon the bullish crossover and exited when the bearish crossover occurred would have realized a 4.04% profit over about 13 days. A trailing stop loss could have exited the position earlier for an even greater profit.
Like any other technical indicator, the vortex indicator works best when it’s used in conjunction with other technical indicators and tends to work better on longer timeframes. A common example would be using the vortex indicator in conjunction with the relative strength index (RSI), which could be used as confirmation of overbought or oversold conditions.
Finally, it’s worth noting that the default parameter for the indicator is 14, like the DMI, but the authors suggest Fibonacci numbers because they are conveniently spaced and provide a good basis for tests. You may want to experiment with different values (we used 22 in the example above) to find out what works best for a specific security and timeframe.
Examples in Action
TrendSpider makes it easy to use the vortex indicator to spot potential trend reversals. In addition, you can use the Strategy Tester to backtest different parameters and create a trading system that generates buy and sell signals and the Market Scanner to find potential trades.
Suppose that you trade the S&P 500 SPDR ETF (SPY) or simply want to find reversals in the S&P 500 to inform the bias you have in all of your trades. TrendSpider’s Strategy Tester makes it easy to whip up a simple long-only strategy whereby you enter into a trade when the VI+ crosses above the VI- and exit with a simple 5% trailing stop-loss.
When backtesting over 2,000 candles (7 months), we find that the strategy returned 6.58% versus 0.85% for buy-and-hold. There were more losing positions than winning positions, but the average winner gained 5.20% versus an average loss of 3.09%. Of course, you may want to expand the test timeline or experiment with other parameters to fine tune your strategy.
You can also use the Market Scanner to scan for all securities in the S&P 500 (or other popular indexes) that experience a VI+ crossing above a VI-. The resulting list could be a starting point for potential trend reversals. Finally, you can convert the scanner into a watchlist that appears on the sidebar at all times to keep in the know.
TrendSpider makes it easy to determine what parameters work best and scan the market for opportunities using the vortex indicator.
The Bottom Line
The vortex indicator is a unique twist on the directional movement index (DMI) that incorporates the concept of natural flow in the market. Most traders watch for crossovers of the VI+ and VI- lines when trading the vortex indicator and use it in conjunction with other technical indicators to spot trend reversals.
TrendSpider makes it easy to actually backtest the indicator to find the best parameters without any coding knowledge necessary, as well as scan different stock market indexes to find potential candidates for trend reversals.