Adaptive Price Zone Technical Indicator Explained

By Jean Folger AAA

The adaptive price zone (APZ) is a technical indicator developed by Lee Leibfarth that was first described in the Technical Analysis of Stocks & Commodities (September, 2006 "Identify the Turning Point: Trading with an Adaptive Price Zone"). The APZ is a volatility based indicator that appears as a set of bands placed over a price chart. Especially useful in non-trending, choppy markets, the APZ was created to help traders find potential turning points in the markets. This article will examine the calculations behind the APZ as well as some of the possible trading applications. (The tenets of market psychology underlie each and every charting tool. To learn more, see Trading Psychology And Technical Indicators.)

TUTORIALS: Analyzing Chart Patterns

Calculating the Adaptive Price Zone
The APZ is based on a short-term double-smoothed exponential moving average that reacts quickly to price changes with reduced lag. An exponential moving average of another exponential moving average (EMA) is utilized to create a fast-reacting average. An exponential moving average gives more weight, or value, to the most recent price data in a specified lookback period. This differs from a simple moving average (SMA) which gives equal weight to all data points in the lookback period. Since an EMA emphasizes the most recent price activity, it is able to respond faster to current price fluctuations and changes in market conditions. The APZ uses the closing prices of a five-period EMA of another five-period EMA.

The adaptive component of the APZ's calculation comes from its use of an adaptive range to measure volatility. This volatility value is achieved by computing the five-period EMA of five-period EMA of the current high minus the current low:

Volatility Value = Five-Period EMA of Five-Period EMA of (High – Low)

The volatility value is then multiplied by a deviation factor (for example, a deviation factor of two) to create the upper and lower bands. The deviation factor will affect the distance that the bands appear from average price; higher deviation factors will encompass price more loosely, lower deviation values will follow price more closely. Once the volatility value has been multiplied by a particular deviation factor, the volatility value is added to create the upper APZ band, and subtracted to determine the lower APZ band:

Upper APZ Band = (Volatility Value * Deviation Factor) + Volatility Value

Lower APZ Band = (Volatility Value * Deviation Factor) – Volatility Value

How It Works
The APZ calculations form two bands that appear over a price chart. The upper and lower APZ bands are neither uniform nor symmetrical. In contrast, the bands that are formed by the APZ take into consideration volatility, and change in shape and width (distance from each other) as changes in price activity occur. In general, the distance between the upper and lower APZ bands will increase with larger price swings, and will constrict during periods of decreased price movement. Therefore, wide bands are indicative of increased volatility, and narrow bands represent periods of decreased volatility. This is shown in Figure 1, a daily chart of the e-mini Russell 2000 futures contract.

Figure 1: This daily chart of the e-mini Russell 2000 futures contract shows how the APZ bands react to changes in volatility. Chart created with TradeStation.

Price activity tends to stay primarily within the APZ's bands. When price crosses above or below the bands, it has deviated from its statistical average, and price consequently has a tendency to return to the statistical average inside the bands. With this in mind, the APZ can help traders identify possible turning points: when price crosses above the upper APZ band, a selling opportunity arises since price has a statistical pull to return to within the APZ's bands; when price crosses below the lower APZ band, a buying opportunity occurs. (By using various technical indicators together, called correlation, traders can bring the "big picture" about a stock into clearer focus. For further reading, refer to 3 Technical Tools To Improve Your Trading.)

Trading Applications
The APZ indicator can be useful for any market or chart interval, and is particularly well-suited to choppy, non-trending markets. The most basic method for using the APZ is to enter a short position (sell) when price violates the upper APZ band; and, conversely, entering a long position (buy) when price breaches the lower APZ band. Figure 2 shows a one-minute chart of the e-mini Russell 2000 futures contract. The yellow, highlighted areas show where price has crossed above or below the APZ bands. These instances are also marked by a small blue dot attached to the price bar where the violation occurred.

Figure 2: This one-minute chart of the e-mini Russell 2000 futures contract shows where price has violated the APZ bands, indicated here by the blue dots (with yellow highlights). Chart created with TradeStation.

While the APZ is useful in establishing potential buy and sell opportunities, its capacity to be used as a standalone trading system is limited. Since the APZ bands are not symmetrical, traders should use profit targets and other money management techniques for closing a trading position. In other words, traders should not simply wait for an opposing signal to close or change a position.

In addition, as with nearly any trading indicator, a separate indicator can be useful for confirming a buy or sell signal. Because the APZ is well-suited for choppy markets, a trend-measuring indicator such as the Average Directional Index (ADX) can be valuable in establishing the relative strength of a trend, thereby confirming or refuting an APZ signal. The ADX, created by Welles Wilder, can help traders determine areas where a trend is losing strength, and, therefore, confirm where price reversals are likely to occur, as indicated by the APZ. The ADX measures the relative strength of a trend, shown on a scale of zero to 100, and typically appears as a curved line below a price chart. ADX levels below 30 and declining represent a weakening trend, and can confirm opportunities for anticipated price reversals shown by the APZ. Where ADX level are above 30 or rising, confirmation does not occur and caution should be taken with any APZ signals. (Follow this tool to reduced risk and increase profit potential. Read ADX: The Trend Strength Indicator.)

Figure 3 shows a chart with both the APZ and ADX indicators. Here, the ADX values remain above 30 for all of the instances where price has penetrated the APZ bands. These potential entry signals can therefore be ignored, since the ADX did not provide any confirmation.

Figure 3: This 144-tick chart of the e-mini Russell 2000 futures contract shows the Adaptive Price Zone indicator used with the ADX for confirmation. In this case, higher ADX values indicate that the trend is still strong, and therefore, the APZ signals are not confirmed. Chart created with TradeStation.

Conclusion
The APZ technical indicator provides traders with a method of spotting potential market reversals. Since the APZ performs best in choppy, non-trending markets, it is recommended that traders utilize a trend-measuring indicator in conjunction to the APZ to avoid trade entries during periods of strong trending market activity.

The inputs for the APZ are adjustable to correspond to the particular trading instrument, chart interval (such as daily, or five-minute) and trading temperament. The deviation setting will have the greatest effect on the indicator, with smaller values following price more closely, and larger values giving price more room to bounce between the upper and lower APZ bands.

Price bands are popular technical indicators for traders. While similar to other bands, the APZ technical indicator uses a faster moving average calculation that enables the APZ to respond more quickly to price fluctuations, particularly during volatile, fast-moving markets.

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