Legendary trader Bill Williams, an early pioneer of market psychology, developed a number of original technical indicators in a career that spanned more than five decades. His trend-following Alligator Indicator follows the premise that financial markets and individual securities trend just 15% to 30% of the time while grinding through sideways ranges the other 70% to 85%.

While pit traders of his era could profit in range-bound periods with swing and scalping techniques, he believed that individuals and institutions away from the exchanges had to book most of their profits during strongly trending periods. Williams invoked barnyard imagery to describe the indicator, noting “even a blind chicken will find its corns, if it is always fed at the same time…. it look us years but we have produced an indicator that lets us always keep our powder dry until we reach the blind chicken’s market.”

Indicator Construction

The Alligator indicator uses three smoothed moving averages, set at five, eight, and 13 periods, which are all Fibonacci numbers. The initial smoothed average is calculated with a simple moving average (SMA), adding additional smoothed averages that slow down indicator turns.

Simple moving average (SMA):

SUM1 = SUM (CLOSE, N)

SMMA1 = SUM1/N

Subsequent values

PREVSUM = SMMA(i-1) *N

SMMA(i) = (PREVSUM-SMMA(i-1)+CLOSE(i))/N

Where:

SUM1 - sum of closing prices for N periods;

PREVSUM - smoothed sum of the previous bar;

SMMA1 - smoothed moving average of the first bar;

SMMA(i) - smoothed moving average of the current bar (except for the first one);

CLOSE(i) - current closing price;

N - the smoothing period.

Three moving averages comprise the Jaw, Teeth, and Lips of the Alligator, opening and closing in reaction to evolving trends and trading ranges:

  1. Jaw (blue line on examples) - starts with the 13-bar SMMA and is smoothed by eight bars on subsequent values.
  2. Teeth (red line on examples) - starts with the eight-bar SMMA and is smoothed by five bars on subsequent values.
  3. Lips (green line on example) - starts with the five-bar SMMA and smoothed by three bars on subsequent values.

Indicator Applications

The indicator applies convergence-divergence relationships to build trading signals, with the Jaw making the slowest turns and the Lips making the fastest turns. The Lips crossing downward through the other lines signals a short sale opportunity while crossing upward signals a buying opportunity. Williams refers to the downward cross as the alligator sleeping and the upward cross as the alligator awakening. (For more, see Read Market Trends With Convergence-Divergence Analysis.)

The three lines stretched apart and moving higher or lower denote trending periods in which long or short positions should be maintained and managed. This is referred to as the alligator eating with mouth wide open. Indicator lines converging into narrow bands and shifting toward a horizontal direction denote periods in which the trend may be coming to an end, signaling the need for profit taking and position realignment. This indicates the alligator is sated.

The indicator will flash false positives when the three lines are crisscrossing each other repeatedly, due to choppy market conditions. According to Williams, the alligator is sleeping at this time, telling market players to remain on the sidelines until it wakes up once again. This exposes a significant drawback because many awakening signals within evolving ranges will fail, triggering whipsaws and shakeouts.

Two Examples

AAPL Alligator

Apple Inc. (AAPL) issues an alligator awakening buy signal in November 2014 and embarks on a strong uptrend that shows an alligator eating with open mouth phase. It tests the Lips a few weeks later, with the bounce telling traders to maintain long positions. An alligator sated sell signal arrives in December when the Lip crosses over to the downside. The alligator sleeps for two months before a new awakening signal goes off, ahead of a two month uptrend that marks another eating with an open mouth phase. The stock then rolls over and settles into a trendless period that triggers numerous false signals, indicating the alligator is sleeping once again and new positions should be avoided.

EUR/USD Alligator

The Euro-US dollar (EUR/USD) currency pair breaks down at the start of 2015, issuing an alligator awakening sell short signal that precedes a strong downtrend. The pattern settles into an alligator eating with mouth open phase while the currency pair tests the Lips three times and sells off, telling short sellers to maintain their positioning. Price action within the rectangle flashes mixed signals because the minor Lips upward cross is insufficient to tell short sellers that the alligator is sated and they should cover positions. A March awakening signal precedes a trip to a multi-year low, with subsequent price action grinding out a brief uptrend, with many trendless price bars and false signals raising the potential for losing positions.

The Bottom Line

Bill William’s Alligator Indicator provides a useful visual tool for trend recognition and trade entry timing, but it has limited usefulness during choppy and trendless periods. Market players should confirm buy or sell signals with a MACD (Moving Average Convergence-Divergence) or another trend identification indicator.

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