Trading Strategies for how to use the Choppiness Indicator
#1 - Buy or Sell the Breakout after extreme Choppiness Index Readings
Now, if you take a browse of the articles on the web, they will simply inform you to buy or sell the break of the 38.2% retracement of the choppiness index as the stock is starting to trend. While this is the basic trigger for the indicator, I think there is more value to this indicator if we dig a little deeper.
For example, when a stock is trending above the 61.8% reading for an extended period of time, this is a sign to you that the market is beyond flat but practically dead.
Therefore, instead of buying or selling the break of the 38.2% retracement, another approach is to wait for a fall back below the 61.8% retracement level to signal a trend is in its infancy.
Couple of points to note is that the choppiness indicator of course would be best used for gauging a breakout after lunch. Any of us that have been day trading for any extended period of time have come to respect the flatness of the mid-day trading session.
Therefore, it is critical for this breakout strategy to (1) occur in the late afternoon and (2) have extreme readings on the choppy index for 1 to 2 hours on a 5-minute chart. This is a sign to you the trader, that when a breakout occurs as the stock is starting to trend, that you may be able to catch some late day fire.
#2 - Ride the Trend using the Choppiness Index Indicator
Beyond identifying when a stock is choppy, the other value add for the choppiness indicator is the ability to stay in a stock when it's trending. Placing a slight twist on the readings for the indicator, try applying the below logic when reviewing the charts.
If the choppiness indicator does not print 3 or more readings above the 61.8% retracement, and the stock is in a strong trend, hold on for the ride.
The key point to bring home is that you have to develop a solid system for determining when a stock is starting to trend. If you are unable to consistently identify a trending stock, you will find yourself making trade decisions based on false signals.
#3 Trade within Choppy Markets
This is an obvious strategy for the choppiness index indicator; I just did not want to lead with this approach in our list of strategies.
Honestly, I do not see the value of using the choppiness index indicator to trade choppy markets. From what I can see of the readings, it is not like you hit the top of a range and therefore volatility should drop off, which should coincide with a subsequent pullback and increase in volatility.
The choppiness indicator is not like an oversold or overbought indicator, so trying to time the moves inside of a tight range could prove a little difficult and may need a little help from a stochastics or Williams R.
Another way of saying this is just because the indicator is at 61.8% does not mean the stock will all of a sudden start trending. You really need price action like in examples 1 and 2 above to increase the level of certainty provided by the indicator.
Lastly, trading the chop, as I call it, has not served me well over the years. Not saying that you cannot figure it out, because choppiness may match your personality to the letter.
#4 - Walk away from stocks that do not trade nicely with the Choppiness Index Indicator
One item to point out is that some stocks will not adhere to the nice boundaries of 61.8% and 38.2% for the choppiness index indicator. You will look at some charts and there will be all sorts of false signals above and below the boundaries of the indicator.
This sort of chart action will be very evident on quick glance. A few breaches of the boundaries does not warrant writing off the indicator; however, if you cannot make heads or tails of it, please do not start modifying the settings to fit each security perfectly.
The reason I say this, is that you are now trying to take an indicator and make it custom for every single stock in the market. Honestly, that sort of effort just is not worth the time. If anything, you want to use the fact the stock does not adhere to the boundaries as a reason to filter out the stock from your list of potential candidates.
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