A mountain and a hill both have ups and downs, but the slopes of a hill are likely to be less steep compared to those of a mountain.
If you are hiking and using a street map as your guide, it might be challenge to determine the steepness of the slopes.
You may need to use a detailed trail-mapping hiking app to help you do a comprehensive analysis of the topography.
Similarly, when looking at trends on stock charts, it may be easy to spot a bullish or a bearish trend, but it can be even more important to determine the strength of that trend and when it will make a reversal.
As traders often say, the trend is your friend whether its bullish or bearish. But how can you tell when a trend is about to stop or reverse?
When it comes to evaluating stocks or market trends, the mass index indicator is a tool that could help identify trend reversals. In this post, we’ll discuss the mass index indicator, including how it is calculated and how you can use it to day trade.
What is the mass index indicator?
The mass index indicator is a technical analysis tool that is used to examine the range between high and low stock prices (volatility) over a specified period of time.
This indicator was developed and introduced by a trader called Donald Dorsey in the early 1990s. Similar to other oscillating indicators, the mass index is designed to help traders find possible trend reversals on a stock chart.
This indicator rises as the difference between the highs and lows (average price range) widens and falls as the range narrows. However, the mass index does not have a directional bias and only serves to signal possible trend reversals.
Mass index indicator calculation
The calculation of the mass index indicator is not really difficult. It involves the following four steps:
- Calculate the single exponential moving average as a 9-day EMA of the high-low differential.
- Calculate the double exponential moving average of the high and low differential.
- Calculate the exponential moving average ratio by dividing the single EMA in point 1 by the double EMA in point 2.
- Lastly, calculate the mass index by calculating the 25-period moving sum of the EMA ratio.
Here is a summary of how the indicator is calculated.
MI = SUM (EMA (HIGH-LOW,9) / EMA (EMA(HIGH-LOW,9)9),N)
Reading the mass index indicator
As mentioned earlier, the mass index is primarily used to identify reversals in a stock or the market.
This indicator assumes that a spike in volatility is usually accompanied by direction shifts, thus traders should regard an increase in the indicator’s value as a possible upcoming trend reversal.
That said, there has to be certain threshold that would help distinguish normal and excessive volatility, and thus create an entry signal when excessive volatility is at play.
The mass index indicator usually ranges around the mid 20s. When creating this indicator, Dorsey said that 26.5 and 27 are the most important numbers.
According to him, a reversal occurs when the indicator climbs above 27 and then drops below 26.5. Dorsey termed this scenario as a “reversal bulge.”
Therefore, a reading below 26.5 usually indicates low volatility while a reading of 27 is usually a sign of high volatility.
Mass index signals and how to trade with the indicator
The first and most basic trading signal given by the mass index indicator is a reversal hump. Traders and chartists primarily use a reversal hump to determine the changes in the trend.
This signal is quite easy to spot on a stock chart and new and inexperienced traders shouldn’t really have any problem spotting it.
The other two important signals are convergence and divergence. Divergence is a mismatch between the indicator reading on a rising bullish trend and the price on the chart.
Convergence, on the other hand, appears on an uptrend and indicates that the trend will soon make a turn in the opposite direction, where the mass index indicator is signaling.
The mass index indicator is best used with price action as it has proven that it can measure the daily high-low range and forecast market reversals with high accuracy.
This indicator doesn’t show the direction of trend movement. If it goes up or down, this doesn’t really mean that prices will go up or down with it. It simply signals that the stock is about to reverse.
This market analysis tool is not an independent indicator and if the line relative to the scale rises or falls, this doesn’t really mean that the trend is also increasing or decreasing, respectively.
The mass index determines only the moment of price reversal and the level of volatility, but not the direction of the trend. As such, it should not be confused with other similar trend counterparts.
Day traders ought to use it when necessary to know the moment a trend ends, the best time to get into a new trade in the opposite direction and get out of the current one.
Regardless of the market conditions, when this indicator gives a reversal signal, the results are the same. It doesn’t matter the extent to which a stock or the market will reverse. The certainty is that the trend reversal signal will be followed by a pullback.
Why you should use this indicator
The mass index indicator can be a great technical tool for day trading or other short-term trading strategies that require traders to take the time to change the time periods based on the historical volatility of the stock that they are looking to trade.
While it’s not common to hear the mass index being talked about in popular trading books or television shows, it is a good indicator when you want to identify reversals on stock charts.
This indicator can improve the timing of your short to decide if it’s okay to enter against the previous trend and in the direction of the new trend.
Second, it is relatively easy to calculate the mass index, although this is not a mandatory thing to know. Finally, the mass index indicator can be found in most trading platforms and its very simple to interpret its readings.
The mass index indicator represents the difference between high and low prices in a stock over a certain period. It can help you spot trend reversals, trade trend continuations, and give you a unique perspective regarding the condition of the market.
But this indicator is also prone to false signals. Therefore, traders should combine it with other indicators such as envelopes and moving averages to improve its accuracy.