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% of the time. (See also: Trade in the Right Direction Understanding Trend-Range Axis.)
Williams believed that individuals and institutions tend to collect most of their profits during strongly trending periods. Williams invoked barnyard imagery to describe the indicator, noting "even a blind chicken will find its corn, if it is always fed at the same time ... it took us years but we have produced an indicator that lets us always keep our powder dry until we reach the blind chicken's market."
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
PREVSUM = SMMA(i-1) *N
SMMA(i) = (PREVSUM-SMMA(i-1)+CLOSE(i))/N
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.
How the indicator is calculated is important for understanding the inner workings of the indicator. Luckily, calculation is not required in practice. Add the Alligator indicator to your charts from the indicator list in your charting or trading platform.
The three moving averages comprise the Jaw, Teeth and Lips of the Alligator, opening and closing in reaction to evolving trends and trading ranges:
- Jaw (blue line) - starts with the 13-bar SMMA and is smoothed by eight bars on subsequent values.
- Teeth (red line) - starts with the eight-bar SMMA and is smoothed by five bars on subsequent values.
- Lips (green line) - starts with the five-bar SMMA and smoothed by three bars on subsequent values.
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 additional reading, 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. Remain on the sidelines until it wakes up again. This exposes a significant drawback of the indicator, because many awakening signals within large ranges will fail, triggering whipsaws.
Facebook, Inc. (FB) has an alligator awakening signal near the bottom left of the chart, then embarks on a strong uptrend that shows an alligator eating with open mouth phase. On the rise, the price drops to the Jaw line, but the indicators do not cross each other. The trend remains up. An alligator sated sell signal arrives when the Lips cross below the Teeth and Jaw lines and lines intertwine as the price moves sideways.
The alligator sleeps for some time before a new awakening signal goes off, and uptrend commences with another eating with an open mouth phase. The price continues to rise, but in weak fashion. Then there is a sell-off and the mouth opens to the downside, signaling a downtrend. The lines cross again, signaling that the alligator is sated. Until the mouth opens again, remain on the sidelines.
The Alligator indicator can be used on any market or time frame. Next is an example from the EUR/USD currency pair.
In the lower left of the chart, the Alligator opens up, and an uptrend remains in place for some time. The lines then cross, and two small downtrends develop. This is followed by a buy signal to the upside, which results in a brief uptrend. As the price pulls back, the Alligator is sated, and then it opens again for a big uptrend. This is followed by an extended sideways period, in which the indicator lines crisscross back and forth. This is a sleeping phase, and most traders are best to stay away. At the far right of the chart, the Alligator is opening its mouth again, or awakening, signaling a downtrend.
The Bottom Line
Bill Williams' 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 can confirm buy or sell signals with a moving average convergence divergence (MACD) or another trend identification indicator. (For more, see: MACD: A Primer.)