Adaptive Price Zone Technical Indicator Explained

What Is the Adaptive Price Zone?

The adaptive price zone, or APZ, is a technical indicator developed by Lee Leibfarth that was first described in the September 2006 issue of the journal, Technical Analysis of Stocks & Commodities in an article entitled “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 on a price chart. Especially useful in non-trending (trading range), choppy markets, the APZ was created to help traders find potential turning points in price movements.

This article examines how the APZ works, the calculations behind it, and some of the possible trading applications for it.

Key Takeaways

• The adaptive price zone is a technical indicator used by traders to assess price action and find reversal points.
• It can be used in any market but is especially useful in choppy trading ranges.
• When a security’s price volatility is high, the distance between the two APZ bands increases; when volatility is stable, it decreases.
• Trade opportunities arise for traders when a security’s price crosses above the top band and below the bottom band.

How the APZ Works

The APZ calculations form two bands that appear on a price chart. These upper and lower APZ bands are neither uniform nor symmetrical. They 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.

Buy and Sell Signals

Price activity tends to stay primarily within the APZ’s bands. When the price crosses above or below the bands, it has deviated from its statistical average. It has a tendency to return to that statistical average inside the bands.

With this in mind, the APZ can help traders identify possible turning points and, therefore, trade opportunities. When the price crosses above the upper APZ band, a selling opportunity arises since, as mentioned, price has a statistical pull that returns it to within the APZ’s bands.

Likewise, when the price crosses below the lower APZ band, a buying opportunity occurs.

Because the APZ adapts to market conditions as they change, it filters out noise and generates fewer false signals than other technical indicators.

Calculating the APZ

The APZ is based on a short-term, double-smoothed exponential moving average, or EMA, that reacts quickly to price changes with reduced lag.

An EMA of another EMA is utilized to create a fast-reacting average. An EMA gives more weight, or value, to the most recent price data in a specified lookback period. This differs from a simple moving average, or 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 found 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 2) to create the upper and lower bands.

The deviation factor will affect the distance between a band and an average price. Higher deviation factors will encompass price more loosely while 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

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.

It’s important to use other technical indicators along with the APZ to confirm its signals. For example, a volume indicator could be used in tandem with the APZ because of the insight volume provides into price movements.

Trading Applications

The APZ indicator can be useful for any market or chart interval, but 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 a security’s price violates the upper APZ band. Conversely, you’d enter a long position (buy) when the 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.

Limitations

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 to close a trading position.

In other words, traders should not simply wait for an opposing APZ signal to close or change a position.

In addition, as with nearly any trading indicator, a separate indicator can be useful as confirmation of a buy or sell signal. Because the APZ is well suited for choppy markets, a trend-measuring indicator such as the Average Directional Index, or ADX, can be valuable in establishing the relative strength of a trend, thereby confirming or refuting an APZ signal.

Use the ADX To Confirm the APZ

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 levels are above 30 or rising, confirmation does not occur, and caution should be taken with any APZ signals.

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 of a weakening trend.

Who Uses the Adaptive Price Zone Indicator?

The APZ can be used by any trader or investor but is used especially by short-term traders and day traders seeking profits in volatile sideways markets.

How Is the APZ Different From Other Price 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.

What Is a Trading Range?

A trading range is price action that remains within consistent high and low prices over time. It is also called a sideways moving market. It is the opposite of a trending market that moves up or down over time.

The Bottom Line

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 with the APZ to avoid trade entries during periods of strongly trending market activity.

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