Donald Dorsey looked for “reversal bulges” to signal a trend reversal. According to Dorsey, a bulge occurs when the Mass Index moves above 27. This initial bulge does not complete the signal, however. Dorsey waited for this bulge to reverse with a move back below 26.50. Once the reversal bulge is complete, traders should use other analysis techniques to determine the direction of the next move. Ideally, a downtrend followed by a reversal bulge would suggest a bullish trend reversal. Conversely, an uptrend followed by a reversal bulge would suggest a bearish trend reversal.
The example above shows Chipotle with the Mass Index producing two reversal bulges over a 12-month period. In both cases, the trend was up when the Mass Index moved above 27, which means a bearish reversal was expected. The first signal foreshadowed a trading range. The second signal foreshadowed a sharp decline. Chartists looking for signals will most likely have to relax Dorsey's requirements for the reversal bulge because the Mass Index rarely exceeds 27. It takes exceptional volatility to push the index above this level.
Chartists can lower the threshold for a reversal bulge to generate more signals. One size does not fit all when it comes to volatility. In other words, chartists may need to compare Mass Index levels over time to identify historical highs and lows. A move that nears the high end of the historical range would suggest a volatility bulge that could foreshadow a reversal.
The chart below shows International Paper with the Mass Index moving above 26 twice. Even though the Mass Index touched 27 in August 2011, the 26 level seems more appropriate for a reversal bulge. Additionally, keep in mind that August 2011 was an extremely volatile period for the entire stock market and this reading looks like an outlier. The trend was down when the Mass Index moved above 26 in August 2011 and May 2012. This suggested that a bullish reversal would follow and chartists could then use other analytical techniques to identify such a reversal.
The bottom indicator is the TRIX oscillator, which is the one-period rate-of-change for the triple smoothed exponential moving average. The TRIX is like the smoothed version of MACD. Once the reversal bulge is in place and the trading bias established, chartists can use the TRIX to generate a directional signal. Because the trends were down when these reversal bulges occurred, the trading bias was bullish and only bullish signals were considered. The green arrows show when the TRIX moved above its signal line to signal an upturn in prices.
The Mass Index uses the high-low differential to provide a smoothed volatility measure. The indicator typically fluctuates in the mid-20s; readings near the high end of the historical range suggest increasing volatility, which increases the chances for a trend reversal. Although Dorsey set the bulge threshold at 27, chartists should consider a lower threshold to produce more signals. Keep in mind that the Mass Index does not have a directional bias. The directional bias depends on the existing trend. As with all indicators, chartists should use other analysis techniques to complement the Mass Index.