One of the easiest ways to identify whether the market is trending or ranging is by using the Choppiness Index indicator. Let’s learn how to make use of this indicator to make smarter trades.
What is Choppiness Index Indicator?
Created by Australian commodity trader E.W. Dreiss, Choppiness Index indicator is based on chaos theory and fractal geometry. This indicator basically helps to identify whether the market is choppy (i.e, consolidating or trading sideways) or not choppy (i.e, trending).
Unlike many other indicators, the Choppiness Index is a directionless indicator. The value of Choppiness Index indicator ranges between 0 and 100. High readings in the Choppiness Index usually happens when there is a significant consolidation in the price action. Similarly, very low readings in the Choppiness Index usually happens during a possible end of strong impulsive movements (up or down).
The Choppiness Index is usually set up with a period of 14. The figure below shows the Choppiness Index Indicator.
Choppiness Index Indicator and Market Trend
The market trend can be identified using the value of Choppiness Index indicator. This is because the choppiness is directly proportional to the value of the indicator. Typically, the higher the number, the choppier the underlying price action and the lower the number, the more trending the price action.
- Choppy: When the value of the indicator is above 61.8, it means that the market is moving sideways in a choppy (consolidating) manner. Usually, the trend continues to be choppy as long as Choppiness index stays above mid 50 line.
- Trending/ Not Choppy: When the value of the indicator is below 38.2, it means that the market is trending. Usually, the stock remains trending as long as Choppiness index stays below the mid 50 line.
- End of Trend: When the value of the indicator is below 30 to 25, it could mean that the prevailing trend may come to an end very soon.
Choppiness Index Indicator and Trend Trading
Traders use the Choppiness Index indicator to pick out trend following trades. Whenever the Choppiness Index indicator stays below 38.2, it is said to be a trending market. So, traders pick out positions in the same direction of the trend as long as the Choppiness Index indicator is below 38.2.
How Traders Use Choppiness Index Indicator
Traders use the Choppiness Index indicator for confirming the prevailing market conditions.
- Consolidating market: Whenever the CHOP readings are above the upper threshold (61.8), it implies continued sideways movement.
- Continuing Trend: Whenever the value of CHOP is below the lower threshold (38.2), it implies that the trend may continue.
- Changing Trend: Whenever there is a prolonged period of consolidation, it would be soon followed by a period of trending. Similarly, whenever there is a prolonged period of trending, it would be soon followed by a period of consolidation. This can be used to identify upcoming changes in trends.
The figure below shows the trending and consolidating phases based on CHOP indicator.
However, do remember that the Choppiness Index indicator is not meant to predict future market direction, but only for defining the market’s trendiness. Many veteran traders usually use Choppiness index indicator in combination with moving averages to get accurate buy and sell signals.