The Vortex Indicator is a volatility-adjusted trending indicator that helps traders determine the short-term trend, spot trading opportunities, and isolate when a trend is not present. It is composed of two lines, and has a relatively straight forward application. Before using the vortex indicator for trading purposes traders should understand how the indicator works, its uses, strategies, and limitations.
How to Use the Vortex Indicator
The Vortex Indicator was created by Douglas Siepman and Etienne Botes and is composed of two lines, +VI and -VI. +VI represents up trending momentum and -VI represents down trending momentum.
The two indicator lines fluctuate above and below 1.0, spreading further apart during very strong trends and moving close together during weak trends or sideways markets.
When the +VI crosses above -VI, it signals a potential uptrend, and as long as +VI stays above -VI it helps confirm the uptrend.
When -VI crosses above +VI it signals a potential downtrend, and as long as -VI stays above +VI it helps confirm the downtrend.
When +VI and -VI are very close together and hovering near the 1.0 mark, it indicates a short-term lack of trend, and a potential consolidation phase in the stock price.
All charts created with StockCharts.com.
Vortex Indicator Calculation
The Vortex Indicator calculation requires five steps:
1. Calculate upward movement and downward movement for the last two periods, using the current and previous one.
- downward movement (-VM) is current low minus previous high (absolute value)
- upward movement (+VM) is current high minus previous low (absolute value).
2. Calculate for periods desired, for example 25 periods.
- -VM25 = 25-period sum of -VM
- +VM25 = 25-period sum of +VM
3. Calculate the True Range (TR). TR is the greatest of the current high less the current low, current high less the previous close, or the current low less the previous close. All must be absolute values.
4. Calculate for the periods desired, for example 25 periods.
- TR25 = 25-period sum of TR
5. Calculate for -VI and +VI.
- -VI25 = -VM25 / TR25
- +VI25 = +VM25 / TR25
A different number of periods could be used in the calculation. Increasing the number of periods, for example to 40, will decrease the sensitivity of the indicator and may be more useful to long-term traders. Decreasing the number periods, for example to 10, will increase the sensitivity of the indicator; very short-term traders may prefer this.
Periods can be days, hourly price bars or 1-minute price bars, or any other period of time.
How to calculate the indicator by hand is good to know, but it’s not required. Many platforms such as Thinkorswim, as well free charting applications such as Stockcharts.com and FreeStockCharts.com, provide the indicator.
Vortex Indicator Strategies
The most basic vortex indicator strategy is to use the crossovers as trade signals: when +VI crosses above -VI, go long; when -VI crosses above +VI, go short. Exit when a crossover occurs in the opposite direction.
Trading this basic strategy without filtering any of the signals can result in whipsaws. A whipsaw is when there is a crossover in one direction, followed shortly after by a crossover in the other direction. Whipsaws can result in a number of losing trades in a short period of time.
To help avoid this, only take +VI crossovers (above
VI) when the overall trend is up. A 100 or 200-day moving average can help establish the trend.
When the overall trend is down, only take -VI crossovers (above +VI).
In either case, use a crossover in the opposite direction as an exit signal. A manual stop loss should also be placed to control risk. For a long trade, place a stop just below a recent swing low, and for a short trade place a stop just above a recent swing high.
Be sure to also read Trend Trading 101
Looking at the Vortex Indicator combined with the trending price in figure two, notice how the large uptrending waves are associated with +VI moving above 1.10 on the indicator, and at no point during this uptrend does -VI move above 1.10. Also note that during the uptrend +VI does not move below 0.90.
Therefore, indicator levels can provide insight into the trend, and provide an additional strategy. This strategy can be combined with the crossover strategy above, or used in isolation.
During an uptrend (price above moving average or making higher swing highs and higher swing lows), either buy on a +VI crossover (above -VI) or when the +VI crosses above 1.10 showing a strong trending move is in place. Hold the trade as long as +VI stays above 0.90 and -VI stays below 1.10. If the +VI crosses below 0.90, or the -VI crosses above 1.10, exit the long trade.
This strategy will result in longer term trades, and will often keep the trader in the position for the majority of the uptrend, and through a number of pullbacks.
During a downtrend (price below moving average or making low swing highs and lower swing lows), either short on a -VI crossover (above +VI) or when the -VI crosses above 1.10 showing a strong trending move is in place. Hold the trade as long as -VI stays above 0.90 and +VI stays below 1.10. If the -VI crosses below 0.90, or +VI crosses above 1.10, exit the short trade as this shows the downtrend has lost momentum.
Figure 3 shows how this strategy would have worked in the same stock. The entry occurs as the price moves above 1.10 signaling the start of a potential trend. This also aligns with the price moving above the 100-day moving average. The long trade stays open as long as the +VI stays above 0.90 and -VI stays below 1.10.
Signals occur less frequently with this method and can capture a larger chunk of the overall trend. It is only useful if a strong trend develops following the entry though
A manual stop loss should also be utilized with this strategy to help control risk in the case of a large adverse price move. After the entry occurs, place a stop loss below a recent swing low for long positions, or above a recent swing high for short positions.
Vortex Indicator Limitations
The greatest flaw of the Vortex Indicator is its susceptibility to “whipsaws.” This can be somewhat offset by using more periods in the indicator calculation, although this will also make the indicator slower to react to trend changes.
The Bottom Line
The Vortex Indicator is an oscillating momentum indicator that helps define the short-term trend. Increase or decrease the number periods used in the calculation to get more or fewer trading signals. When +VI is above -VI it helps identify the uptrend, and when -VI is above +VI it helps identify the downtrend. Using indicator levels, such as 1.10 or 0.90, show when a trend is gaining momentum or losing it. Price analysis should still be used in conjunction with the indicator, as the indicator is prone to providing false trading signals (whipsaws); price analysis can help you determine the overall and longer-term trend and trading direction. A moving average may also be of use in determining trend direction.
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