How to Use the Mass Index
The Mass Index is a measure of volatility that can be extremely helpful in identifying reversal patterns. While it does not predict the direction of a reversal, the indicator has proven to be quite accurate in analyzing trading ranges to determine when a reversal is likely to occur, particularly over long periods of time. As a result, the indicator should be an instrumental part of any traders toolbox.
In this article, we’ll take a closer look at the Mass Index, interpreting its readings, and some limitations for traders to consider.
What Is the Mass Index?
The Mass Index is a volatility indicator developed by Donald Dorsey and discussed in the June 1992 issue of Technical Analysis of Stocks & Commodities. By analyzing the narrowing and widening of trading ranges, the indicator identifies potential reversals based on market patterns that aren’t often considered by technical analysts largely focused on singular price and volume movements.
See also our Guide to the Average True Range (ATR) Indicator
Since the signals do not provide insight into the direction of the reversals, technical analysts should combine the indicator’s readings with directional indicators like the AD Line that specialize in predicting those types of things.
The Mass Index is calculated by taking the sum of multiple ratios of single and double exponential moving averages (“EMAs”) over time, as illustrated in Figure 1.
The four steps to completing the calculation, including:
- Calculate a 9-day EMA of the difference between the high and low prices.
- Calculate a 9-day EMA of the moving average calculated in Step 1.
- Divide the EMA calculated in Step 1 by the EMA calculated in Step 2.
- Total the values in Step 3 for the desired number of periods.
Interpreting the Mass Index
The Mass Index highlights potential reversals in the form of “reversal bulges”, according to Donald Dorsey. These “reversal bulges” are characterized by the indicator’s move above the 27.00 level and then back below the 26.50 level (in order to confirm the move). Of course, these levels and the Mass Index’s other settings can be modified in order to increase the number of signals or enhance accuracy.
Be sure to also read A Trader’s Guide to Understanding Business Cycles
Let’s take a look at a quick example:
In Figure 2, Microsoft Corporation’s (NASDAQ: MSFT) Mass Index “reversal bulge” indicates an upcoming change in direction. The AD Line shows that the trend reversal will likely be bullish in nature since traders have been starting to accumulate the stock. After a brief retracement, the long-term bullish uptrend begins to show by September 2014 and continue through August 2014.
In Figure 3, Groupon Inc.’s (NASDAQ: GRPN) Mass Index “reversal bulge” indicates an upcoming change in direction. The bearish MACD crossover suggested an upcoming downtrend and the stock price subsequently fell from about 12.50 to below 6.00 when the Mass Index crossed below 26.50. Traders that considered the sell signal could have either exited a long position or entered a short position.
Limitations of the Mass Index
The Mass Index suffers from the same limitations as many other reversal indicators – false signals. Traders can mitigate the effects of false signals by using the indicator in conjunction with other technical indicators designed to confirm reversals. For example, a relative strength index reading above 70.0 and a bearish MACD divergence may confirm a Mass Index prediction of an upcoming reversal.
Another limitation to consider is the lack of a directional prediction, as discussed in the previous section. The best way to determine the direction of the reversal, traders should use outside indicators like the AD Line seen in Figure 2 or other tools like the TRIX indicator, which serves as a smoothed MACD of sorts. The TRIX can be especially helpful in reducing the noise when generating trading signals.
The Bottom Line
The Mass Index is a volatility indicator developed by Donald Dorsey that analyzes the narrowing and widening of trading ranges. It is calculated by taking the sum of multiple ratios of single and double exponential moving averages (“EMAs”) over time. Mass Index “reversal bulges” are characterized by the indicator’s move above the 27.00 level and then back below the 26.50 level. The Mass Index has many important limitations that traders should understand before using it, including the risk of false signals.
Did you know that...
- The 'herding effect' describes investors' tendencies to follow the majority, which can exacerbate market booms and busts?
- Ray dalio, the founder of bridgewater associates, is an advocate for diversification and created the "all weather" portfolio to withstand any market condition?
- While traditional metrics like p/e ratios are commonly used for evaluating growth stocks, many investors also look at forward-looking indicators like projected earnings growth, user growth, or industry trends to gauge asymmetric risk and potential?
- Momentum investing involves buying stocks that have been performing well recently and selling those that have been performing poorly?
- 'pair trading' involves buying one stock and shorting a related stock, betting on the relative performance of the two?
Quotes of the Day:
- "The most important thing in investing is to be contrarian." - Marty Whitman
- "I've always believed that if you want to be successful, you have to be willing to work harder than anyone else." - T. Boone Pickens
- "The best investment you can make is in yourself." - Charles Brandes
- "The stock market is a device for transferring money from the impatient to the patient." - Julian Robertson
- "Investing is not about being right all the time, it's about minimizing your losses when you're wrong." - Peterffy Thomas
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