Volume Trading Strategy: Yo-Yo Indicator, Trend Confirmation

Yo-Yo Indicator

The catchphrase Yo-Yo indicator was developed by Richard Arms Jr., the creator of the ARMS Index, and was explained in an article he penned for Barron's in 1998. It combines the daily spread of a stock or index and divides daily volume by that number to figure out how many shares it takes to move a stock or index through one point of its spread (daily range).

On a historical basis, more volume is required to generate a wider price swing at the tops, while the opposite is true at the bottoms. This may be explained by the emotions of greed and fear. At tops, there is complacency, which requires increased volume to get prices to swing in wider ranges. At the bottom there is fear, which causes prices to swing more widely, thus providing extra “juice” to lower-volume numbers.

Chart 8.93 Yo-Yo Indicator, Nasdaq Composite Daily    

Formulation

This is the formula for the Yo-Yo indicator:

While the Yo-Yo indicator was developed to exploit the emotions of greed and fear, we have found it to be a versatile tool that can actually trend with price as well as show divergences between price and the indicator, which alerts traders that a change in direction is due. The Nasdaq Composite plot in Chart 8.93 shows how lows in the Yo-Yo indicator coincide with short-term market lows.

Trend Confirmation

The Yo-Yo indicator is also good at confirming trends and typically coincides with market low points. In an uptrending market, the indicator tends to make higher lows, mirroring the price movement. This shows that the level of panic on sell-offs subsides as uptrends develop, demonstrating

Chart 8.94 Yo-Yo Indicator, Uptrend Confirmation, Nasdaq Composite Daily

positive sentiment among traders. The Nasdaq Composite view in Chart 8.94 shows how the Yo-Yo indicator trends right along with the index. Note the positive divergence (lower lows on prices, higher lows on the indicator) at the March 2009 low.

The plot of the Nasdaq Composite in Chart 8.95 shows how the Yo-Yo indicator trended lower with prices from October 2007 through December 2008.

Divergences

Chart 8.96 gives a closer look at the positive divergence that developed in the Nasdaq Composite preceding the March 2009 low. Note how the indicator bottomed a full two months before price did. That is continued evidence that divergences should not be traded until price confirms a change in trend direction.

The Yo-Yo indicator is also useful across multiple time frames. The weekly chart of the S&P 500 in Chart 8.97 shows a very large negative divergence beginning in early 2007. Notice how prices continued higher for weeks while the indicator began trending lower. This was a full 10 months before the fall top, but it was an indication that there was real trouble ahead.

Chart 8.95 Yo-Yo Indicator, Downtrend Confirmation, Nasdaq Composite Daily

Chart 8.96 Yo-Yo Indicator, Positive Divergence, Nasdaq Composite Daily

Chart 8.97 Yo-Yo Indicator, Negative Divergence, Nasdaq Composite Daily

Trade Setup

The Yo-Yo indicator is an effective tool to spot a change in sentiment that can tip traders that a change in direction is due. In the example in Chart 8.98, the Yo-Yo indicator is plotted below a price chart of the DJ Diamonds Trust ETF (DIA). Note how the Yo-Yo indicator made slightly lower lows as the selling progressed from February 2004 to August 2004. Notice on the final corrective low in October 2004 how the Yo-Yo indicator made a much higher low, showing a divergence between trader sentiment and price action. The divergence was a clue that the trend was about to change. Confirmation by price action in the form of an upside break of the downsloping resistance line connecting the September 2004 and October 2004 highs would signal a trade entry.

Trade Entry

As Chart 8.98 reveals, price declined during 2004, making lower highs and lower lows; the Yo-Yo indicator confirmed each low by making a slightly lower low each time until the month of October. As price declined into what turned out to be the final low for the move on October 25, 2004,

Chart 8.98 Yo-Yo Indicator, Positive Divergence Trade Setup, DJ Diamonds Trust ETF

the Yo-Yo indicator had already begun to make higher lows, displaying a reduced level of fear. The only piece of the puzzle left was for price to confirm a trend reversal by taking out the resistance line drawn over the September-October highs (see Chart 8.99). On November 3, 2004, price closed above the downsloping resistance line, which was the signal that the trend was ready to reverse. An initial protective stop should have been placed below the October 25 low of 97.27.

Trader Tips

The Yo-Yo indicator was developed to track and exploit the emotions of fear and greed. It is also a versatile tool that can do the following:  

• Confirm market trends
• Show divergences that lead to short-term changes in direction
• Be used over longer time frames to give a big-picture look at market trends

While the Yo-Yo indicator was developed with a single purpose in mind, it is a versatile analysis tool that can perform multiple functions.

Chart 8.99 Yo-Yo Indicator, Positive Divergence Trade Entry, DJ Diamonds Trust ETF

Summary