In the previous blogs, we have covered Moving averages and Trend lines. The ‘Alligator’ Indicator covered in this blog is a mix of both. It helps to identify the trend through moving averages. The Indicator was derived by Bill Willams with the notion that the markets are only trending 30% of the time and remain consolidated 70% of the time. Thus, ideally, it can be used on higher time frames such as daily or weekly to determine the directional bias of any financial instrument.
It is favored more for swing traders who prefer to hold on to positions for a longer duration. At first, we will understand what the Alligator indicator is and how it is interpreted. This will be followed by how you can use it for technical analysis to assist in your trading.
IMPORTANT: This mini series of forex trading blogs are not considered advice on how you should trade, but merely is providing a tool you can use to compliment your existing fx trading strategy.
What is William’s Alligator?
The analogy for this indicator is made with an Alligator to better explain how it can be interpreted. The Alligator indicator comprises the three 3 balance lines which are as follows:
- Simple Moving Average (SMA) set to 5 periods and then is smoothed by 3 bars into the future. It is referred to as the ‘Lips’ of the Alligator.
- Simple Moving Average (SMA) set to 8 periods and then is smoothed by 5 bars into the future. It is referred to as the ‘Teeth’; of the Alligator.
- Simple Moving Average (SMA) set to 13 periods and then is smoothed by 8 bars into the future. It is referred to as the ‘Jaw’ of the Alligator.
*Mathematical derivation of the indicator is excluded for simplicity and the emphasis is on the conceptual interpretation.
In order to understand how it works, let us first take a look at what the Alligator indicator looks like on a chart.
- The green line is the 13-period smoothed moving average which is called the ‘Jaw’ of the Alligator.
- The red line is the 8-period smoothed moving average which is called the ‘Teeth’ of the Alligator
- The blue line is the 5-period smoothed moving average which is called the ‘Lips’ of the Alligator.
The idea behind this indicator is to sit back and observe when the market is in a consolidated range and enter the market as soon as it starts trending. The consolidated range is identified when you observe the 3 balance lines (jaw, teeth and lips) crossing each other which indicates a period of sideways movement. This is when the Alligator is sleeping (look at it as the calm before the storm). This is shown by the red line in the chart of XAUUSD (Gold) above.
The Alligator starts eating as soon as it wakes up, which is observed when the Green line (Jaw) > Red line (Teeth) > Blue line (Lips) for a bullish move. Likewise, when the Green line (Jaw) < Red line(Teeth) < Blue line (Lips), it is a bearish move. This can also be seen from the green line in the chart above. This is when the market switches to trending. It is also seen that the longer the consolidated range the stronger the trending move.
Now that we have understood how the Alligator indicator can be interpreted. Let us now see how a trade setup can be formed through this.
How do I use Alligator Indicator to execute trades?
As mentioned earlier, it is favored more for swing traders who prefer to hold on to positions for a longer duration. However, it can also be used for day trading on smaller time frames.
We will look at an example where we will first take a daily time frame to learn the directional bias i.e. the potential trending direction of the market. Once we have identified that, we will look for a trade position in favor of the direction.
Below is the chart of EURUSD on the Daily time frame. Here from March 16th to May 27th, we noticed a consolidated phase where all 3 balance lines were crossing each other indicating a sideways movement for approximately 3 months. As it can be seen, after that period, the Alligator wakes up and starts a trending (bullish) move. Here we created our directional bias and look for buy/long entries.
Once the balance lines start getting further apart from each other, we can enter a buy position as shown in the chart below.
The first buy indicated is after you observe that the Alligator has woken up. This is observed by the balance lines going further apart from each other. You can move on to smaller time frames and enter when the price is retesting the balance lines as well. There is not one particular way for entry. It can vary from trader to trader based on what entry strategy they prefer. Here a buy position is taken as soon as the difference between the balance lines has grown bigger.
The Second buy is based on the retest of the price towards the ‘teeth’ of the Alligator for the continuation move. The first potential exit can be identified when the balance lines start joining each other which indicates an exhaustion in trend. Therefore, this can be seen as taking profit level. Second potential exit is also based on observing the balance lines joining together thus indicating an exhaustion in momentum.
Had the trade not worked out in your favor, you can exit your trade if the Jaw line crosses the Lips. This is indicated by the red line as a potential exit.
Be mindful that there is not one or fixed way of trading using any indicator. However, understanding how the Alligator indicator works can help the traders in identifying the long term direction of the market if it is analyzed on a daily or weekly timeframe. Subsequently, traders can use different tools on top of it to create confluences with other elements. Likewise, the same pattern can be observed in a bearish trend.
When you are trading at any prop firm or trading a live funded account, you should always practice good risk management. Have a stop loss, control your lot size and use what you feel comfortable trading. Traders must incorporate risk management no matter what strategy it is as that is the only way to see consistent profitability and growth in the long term.
Stay tuned for more!