TREND OR NOT A TREND

Law #9: Use ADX. The Average Directional Movement Index (ADX) line helps determine whether a market is in a trending or a trading phase. It measures the degree of trend or direction in the market. A rising ADX line suggests the presence of a strong trend. A falling ADX line suggests the presence of a trading market and the absence of a trend. A rising ADX line favors moving averages; a falling ADX favors oscillators. By plotting the direction of the ADX line, the trader is able to determine which trading style and which set of indicators are most suitable for the current market environment.

As we saw with the Dow Jones chart in the last issue, determining when a new trend has started is difficult at best. If only there was a way to see how "strongly" a stock is trending. Well, that's exactly what the ADX line does! Check it out:

Here's a longer-term, weekly Dow chart. The blue vertical lines show where the Red and Green +DI and -DI lines cross inside of the ADX indicator window. Ignoring some lag -which is common with a 14-week indicator like this - you can see that those blue lines divide the chart into a downtrending period, an uptrending period, and a mixed period (from April onwards). The best example of using the black ADX line that John was talking about can be seen during the downtrend period (from April 2002 to May 2003).

Initially, the ADX line is quite low as the new downtrend gets established. By July 2002, it is rising quite quickly meaning that the downtrend is strengthening. This is the time when, according to John, you should favor moving averages for trading signals.

The downtrend bottoms out in early October, just as the ADX hits its peak. The ADX then begins a slow decline that lasts until May 2003. That is the period on the chart during which John says you should favor Oscillators for trading signals.

More Info:
The ADX was developed by Welles Wilder as part of his "Directional Movement Index (DMI)" system. It was first described in his book New Concepts in Technical Trading back in 1978.

Note: John's entire 10 Laws of Technical Trading can be found in our "ChartSchool" area under "Trading Strategies". If you missed any of my previous articles on Murphy's Laws, the ChartWatchers Archives page will take you to any of them.

- Chip Anderson