ADX for V Tops and V Bottoms

We have often described how the ADX (J. Welles Wilder's Average Directional Index) can be a useful tool for measuring the strength of trends. (Please review: Contradictions in using ADX and  ADX Has it's Limitations if you are not familiar with our recommended use of ADX.) To briefly summarize our previous advice, we have found that when the ADX begins to rise it is telling us that a strong trend is developing. A rising ADX has proven to be a particularly reliable indicator after a market has been going sideways for a while and then begins to trend. For best results, the ADX should begin its rise from a low level (less than 15 or 20) because the low level of the ADX indicates that a sideways basing pattern has been formed. Most of our applications of the ADX strategy have been predicated on finding these highly profitable patterns where a trend suddenly emerges after an extended sideways period.

Unfortunately not all trends begin with a sideways pattern. There are many V tops and V bottoms that our rising ADX strategy fails to capture. In a V pattern the ADX rises and then peaks out and declines. The ADX does not begin rising again in time to catch the change in direction in a timely fashion. By the time the ADX falls and then begins to rise again a major portion of the new trend will have already been completed. As we have pointed out in our previous Bulletins, any entry on a rising ADX that was not preceded by an extensive sideways period is not a very reliable pattern.

Recently in our research on using the ADX for trading stocks we have observed another ADX pattern that we believe shows great promise. This new ADX pattern signals very timely entries that allow us to profit from possible tops and bottoms that are V shaped.

Here is how these V shaped top and bottom patterns can easily be recognized:
1. Make sure that your plot of the ADX also includes the plot of the Plus DI and the Minus DI. The pattern begins when the ADX is above both the Plus DI and the Minus DI. Most often when the ADX is above both the Plus and Minus DI the ADX will be at a high level, perhaps greater than 30 or 35. The high level of the ADX indicates that the previous trend was a very strong one. Now we are going to try and catch the reversal of that strong trend.
2. With the ADX at a high level and declining, look for a crossing of the Plus DI and Minus DI. If the Minus DI crosses above the Plus DI it indicates that a strong up market has ended and weakness has set in. If the Plus DI crosses above the Minus DI it indicates that a strong downtrend has ended and a new uptrend can be expected.
3. These reversal patterns should be entered only as the market moves in the new direction. (We suggest that you use stops for entry triggers.) Once you have entered the trade you should expect a substantial move in the new direction.
4. Be sure to use a stop loss at the recent low or high of the previous trend. Be willing to make more than one attempt to catch the new trend. (Sometimes the Plus and Minus DI will cross back and forth more than once before the new trend emerges.)

We have found that this simple pattern identifies major changes in direction in almost any market. However you should be aware that the change of direction pattern we have described is not as reliable as the typical rising ADX pattern that starts with a basing action. However the trades that do work are exceptionally profitable and we know of no other method that is as timely at catching major changes in direction. Most traders take a great deal of personal satisfaction in quickly recognizing major changes in direction. This simple entry method can produce some truly outstanding trades and provides a welcome change from typical trend following strategies.

Our Phoenix Bond system uses this technique to identify major bottoms in the bond market. The same system also spots bottoms in individual stocks. To catch major tops we simply reverse the logic. Just put up some charts with the ADX and look for the pattern we have described in this Bulletin. We think you will be very surprised at its accuracy. Give us your comments and observations on the Forum.

Good luck and good trading.