Vortex indicator explained: How to read it and how to use it
The vortex indicator is a useful tool when it comes to discovering market trends.
- What is the vortex indicator?
- How to read the vortex indicator
- How is the vortex indicator calculated?
- How to use the vortex indicator
- The drawbacks
What is the vortex indicator?
The vortex indicator is one of many data-related tools which can be used to measure the status of a market, what the current trends are and what direction it is moving in. It can be used, alongside other data tools, to help traders make predictions.
One interesting thing about the vortex indicator is that it is a relatively new statistical development. It was created in 2010 by two Swiss market technicians, Etienne Botes and Douglas Siepman, based on the idea that movements up and down in financial markets are similar to the vortexes seen in flowing water, and it builds on work carried out by J. Welles Wilder, one of the big names in the development of technical trading systems, who died in April 2021 aged 85.
The indicator, at first instance, looks fairly straightforward. There are two lines which oscillate over the chart. When they cross, that means that the market is either getting bullish, with more people wanting to buy the stock, or bearish, meaning more people are wanting to sell it.
The indicator is used to measure where the overall trends in the market change. These changes are called “reversals”: though the word “reversal” often has negative connotations, all it means here is change. It does not necessarily mean the stock has got worse.
Although we will talk about stocks in this piece, the vortex indicator could theoretically be used for anything. You can put a vortex indicator on a cryptocurrency price chart, for instance, and it would do the same job as it would with traditional stocks and shares. We are using stock prices here because it is a bit easier and more convenient. Do not be put off using a vortex indicator just because you are not trying to analyse stocks and shares.
How to read the vortex indicator
As we have said, the vortex indicator consists of two lines. One, VI+, indicates positive market movement, or growth, and the other, VI-. indicates negative market movement, or loss. These are measured over two periods. The periods chosen are usually days, although you can set the indicator to measure whatever time period you would like.
Overall, there are usually 14 periods in the chart. If we look at the chart, we can see that there are times when the two lines cross over. If we are in a phase where things are looking bullish, the +VI line will be up and if we are in a phase where things are looking bearish, then the -VI line will be up.
What is interesting about the indicator is that one line is always going to be higher than the other. There is no space for ambiguity. The vortex indicator is always going to be telling us if the market is either bullish or bearish. Although this does not tell the whole story, it can be good to have a snapshot of the current position.
How is the vortex indicator calculated?
The vortex indicator is based on a calculation which is split into four parts.
First, there is the True Range, or TR. This is calculated by finding out the current high minus the current low, the current high minus the previous close and the current low minus the previous close and finding out which is the biggest of the three.
Second, there is the uptrend movement, or VM+, and the downtrend movement, or VM-. The VM+ is the absolute value of the current high minus the prior low and the VM- is the absolute value of the current low minus the prior high.
Third, you have the parameter length, or n. This is usually somewhere between 14 and 30 days. You take the total of the time period’s true range, VM+ and VM-. Then you work out the true range over the length of n to get TRn, the VM+ over the length of n to get VM+n and the VM- over the length of n to get VM-n.
For the final bit of the vortex indicator formula, you divide VM+n by TRn to get your VI+ and you divide VM-n by TRn to get VI-. It looks complicated but once you get your head around it its fairly straightforward. In any case, the program should do it for you.
How to use the vortex indicator
Let us use an example of a stock price graph with a vortex indicator running below it. In this demonstration, the VI+ is red and the VI- is blue. Let’s take a look.
If we examine this chart, we can see that the time period is 14 days. We can also see that the price is pretty volatile at the moment but, because the red bar is above the blue bar, we are in a bullish phase.
We can also learn that the trends have changed a fair bit recently, and that it was not that long ago at all that we were in a bearish phase. We can use this information to inform our decisions about this particular stock.
While the vortex indicator is useful, it is not perfect. Firstly, it can only tell you what has happened and what is happening, not what is going to happen.
If you are investing, you need to do your own research, remember that prices can go down as well as up, that prior performance does not reflect future results and to never invest more money than you can afford to lose.
Also, because the vortex indicator deals with oscillations in the market, sometimes it can give off false signals, especially if the n is over a relatively short time period.
Finally, the vortex indicator is only a little over 10 years old, so it has not been as well-tested as some other statistical tools. Nevertheless, the vortex indicator can be a very helpful element of data analysis when you have a vortex indicator strategy which is combined with other statistical tools.