ADX Has its Limitations

(I'm referring to Welles Wilders Average Directional Index in case you are a "newbie".) After many years of extolling the virtues of the ADX in articles and lectures all over the world I have become closely associated with this indicator. That's fine with me and I don't mind being considered the resident expert on ADX. It is an excellent measure of trendiness and a good indicator to be linked with.

However, I think it is a mistake to try and over work or become too dependent on any one indicator. If you were going to build a house you would need more than one tool and you wouldn't try to do it with just a hammer. The same is true of building systems. The ADX can be a very valuable tool if used correctly but it has some major shortcomings that everyone should be aware of: We all know that the ADX is slow. This is because of all the smoothing in the formula. The basic ingredients are smoothed and then the results are smoothed again. For example I think it takes more than 30 bars of data to calculate a 14 bar ADX. This smoothing makes the ADX slow but there is an even greater problem than just the speed of the indicator. The logic of measuring directional movement makes the ADX very reliable at certain times and very unreliable at other times.

A rising ADX is a reliable indication of a trend when there has been an extended sideways period before the trend gets started. Before all the high tech computer mumbo jumbo we used to simply refer to this sideways period as a "basing pattern". The ADX is most effective when it begins to rise from a low level (low = 15 or less). This low level on the ADX indicates that there has been a basing pattern for a while. This interpretation is contradictory to those users of the ADX who want to see the ADX cross above a specified threshold (usually 20 or 25) to indicate that a trend is underway. This technique would make the ADX even slower and means you would be confirming a trend and entering your trade long after the basing pattern was broken. But even if you were late due to your method of interpreting the ADX, following the ADX after a base pattern is still quite reliable. The potential problem I want to bring to your attention in this article is the action of the ADX after major peaks and valleys.

The logic of the ADX is best visualized as measuring directional movement over a moving window of data on a bar chart. If we have sideways data in the window followed by recent trending data (lets think of rising prices but it could be the reverse), the rising prices would show directional movement relative to the sideways data at the beginning of our window. The ADX would promptly rise and call our attention to the fact that there is now a direction in prices that should continue for a while.

However, if the prices rise for an extended period and then begin to fall sharply (a typical scenario) we now have a window of data that shows rising prices followed immediately by falling prices. The ADX formula measures the rising prices in the window and compares them with the declining prices in the window. Because the two trends are about equal they cancel each other and the ADX does not detect any net directional movement. The ADX now begins to decline indicating that it is finding no net directional movement in the period measured by the window.

As the window moves forward, eventually the older rising price data falls outside the back of the window so that the window now contains only the more recent downward price movement. The ADX suddenly begins to rise rapidly because the data window at this point contains only one trend. The problem with this new signal is that the downward trend in prices has been underway for quite some time and only now has the ADX finally begun to rise. This is obviously not a good point to be entering a trade to the short side. We are probably nearer the end of the trend than the beginning.

Remember that the ADX works best after a basing period and is unreliable after a "V" bottom or top.
That"s all for now. I'll continue this discussion of the ADX in our next bulletin which should be out very soon.

ADX Has its Limitations

(I'm referring to Welles Wilders Average Directional Index in case you are a "newbie".) After many years of extolling the virtues of the ADX in articles and lectures all over the world I have become closely associated with this indicator. That's fine with me and I don't mind being considered the resident expert on ADX. It is an excellent measure of trendiness and a good indicator to be linked with.

However, I think it is a mistake to try and over work or become too dependent on any one indicator. If you were going to build a house you would need more than one tool and you wouldn't try to do it with just a hammer. The same is true of building systems. The ADX can be a very valuable tool if used correctly but it has some major shortcomings that everyone should be aware of: We all know that the ADX is slow. This is because of all the smoothing in the formula. The basic ingredients are smoothed and then the results are smoothed again. For example I think it takes more than 30 bars of data to calculate a 14 bar ADX. This smoothing makes the ADX slow but there is an even greater problem than just the speed of the indicator. The logic of measuring directional movement makes the ADX very reliable at certain times and very unreliable at other times.

A rising ADX is a reliable indication of a trend when there has been an extended sideways period before the trend gets started. Before all the high tech computer mumbo jumbo we used to simply refer to this sideways period as a "basing pattern". The ADX is most effective when it begins to rise from a low level (low = 15 or less). This low level on the ADX indicates that there has been a basing pattern for a while. This interpretation is contradictory to those users of the ADX who want to see the ADX cross above a specified threshold (usually 20 or 25) to indicate that a trend is underway. This technique would make the ADX even slower and means you would be confirming a trend and entering your trade long after the basing pattern was broken. But even if you were late due to your method of interpreting the ADX, following the ADX after a base pattern is still quite reliable. The potential problem I want to bring to your attention in this article is the action of the ADX after major peaks and valleys.

The logic of the ADX is best visualized as measuring directional movement over a moving window of data on a bar chart. If we have sideways data in the window followed by recent trending data (lets think of rising prices but it could be the reverse), the rising prices would show directional movement relative to the sideways data at the beginning of our window. The ADX would promptly rise and call our attention to the fact that there is now a direction in prices that should continue for a while.

However, if the prices rise for an extended period and then begin to fall sharply (a typical scenario) we now have a window of data that shows rising prices followed immediately by falling prices. The ADX formula measures the rising prices in the window and compares them with the declining prices in the window. Because the two trends are about equal they cancel each other and the ADX does not detect any net directional movement. The ADX now begins to decline indicating that it is finding no net directional movement in the period measured by the window.

As the window moves forward, eventually the older rising price data falls outside the back of the window so that the window now contains only the more recent downward price movement. The ADX suddenly begins to rise rapidly because the data window at this point contains only one trend. The problem with this new signal is that the downward trend in prices has been underway for quite some time and only now has the ADX finally begun to rise. This is obviously not a good point to be entering a trade to the short side. We are probably nearer the end of the trend than the beginning.

Remember that the ADX works best after a basing period and is unreliable after a "V" bottom or top.
That"s all for now. I'll continue this discussion of the ADX in our next bulletin which should be out very soon.

The Parabolic Trigger for V Tops and Bottoms

Our previous article about using the ADX for V shaped tops and bottoms was surprisingly well received. We had a great deal of very favorable feedback from our members who experimented with it. This very valuable pattern seems to do an excellent job of spotting major turning points in almost any market from Palladium to Natural Gas to Soybeans or even Lumber. This pattern seems to work extremely well in almost all futures, stocks and even the hard to trade stock indexes.

Much like a kid with a new toy, we've been having fun scanning through our charts and finding all the important signals that have been generated. For example, when looking at the stock index charts we had some very timely and important signals that the strong bear market in stocks was finally reversing. Let's review very briefly the conditions that create the pattern we are looking for.

REVIEW OF SETUPS and TRIGGERS: For those of you who are new to our work, we strongly recommend a two step process for entries. The first step is to identify some "setup" conditions that tell us that an entry is near. The second step is the "trigger" that tells us we must enter the trade NOW.

Just to refresh your memory from the previous Bulletin, let me review the "setup" conditions that we are looking for. Remember that we are trying to anticipate important "V" shaped reversal patterns. We want to be able to trade as near as possible to major tops and bottoms. As most of you are aware, a major directional price move will cause the ADX to rise to a high level. Depending on the direction of the price movement, either the Plus DI or the Minus DI will also move to an unusually high level. As the market peaks the DI will begin to decline while the ADX is flat or still rising. Near the top (or bottom) the ADX will become the highest line and will be above both the Plus DI and the Minus DI lines. This is our "setup" and alerts us that an important change in direction is likely in the very near future. The relationship of the three lines with the ADX being the highest tells us that there has already been a very extended price move that is running out of gas.

FINDING A TIMELY TRIGGER: While studying the charts using our new ADX pattern we found that our setup conditions often occurred early and that our DMI triggers were sometimes a little bit late. We don't mind having the setup conditions occur early. After all, lead indicators are rare and very hard to find. However to make this entry pattern even more exciting we thought we would see if we could make the triggers occur sooner.

Now that we have our lead indicator in place we want to find a timely entry trigger that gets us started in the direction of the new trend that should just be getting started. In Bulletin 45 we suggested that the crossing of the Plus DI and Minus DI lines could be the entry trigger. Although this method is acceptable and produces excellent results we observed that there might be room for further improvement. In many cases, by the time the Plus and Minus DI have crossed some profits in the new direction have already been left behind.

After some trial and error we found that the Parabolic indicator did just what we wanted. We believe we can use the Parabolic indicator instead of the DMI crossovers to provide much more timely entry triggers.

We have never liked the Parabolic stop and reverse (SAR) method as an independent trading system which was the intent of J. Welles Wilder, its originator. However we do like to use the Parabolic indicator for exits. As a system we find that the Parabolic reversal points occur much too frequently and this reversal system would drive us crazy with far too many false changes in direction. However the features of the Parabolic indicator that make it useful as an exit strategy are exactly what makes it the timely trigger we need for our ADX reversal pattern.

The Parabolic indicator accelerates steadily as the prices trend until the reversal points are very, very close to the peak of the move. The stronger the trend the closer the Parabolic gets to the prices. That is exactly what we want. When the Parabolic indicator is close to the prices and we have fulfilled our ADX setup conditions we are all set for an outstanding trade. Even a very small countertrend move will now quickly cross the Parabolic and signal our timely entry.

AN IDEAL ENTRY PLUS AN ADD POINT: We view the marriage of the ADX setup with the Parabolic entry trigger as an ideal combination. The entries now occur in a much more timely fashion than when we relied on the DI crossovers for our trigger. In fact, once the Parabolic has been crossed we can use the DI crossover as a confirmation and add to our position. I don't normally believe in pyramiding positions but in this case we are trading a very reliable pattern that is designed to identify a major reversal in direction, so I think that adding to positions early is a very good strategy.

As you can probably tell, I really like this ADX and Parabolic entry technique and I think that we have a lot of good concepts working for us here. We have an early setup, a timely trigger and now we can use the delayed confirmation of the DI crossovers as a point to pyramid the position. You can't ask for much more than that for an entry strategy that does a great job of catching big moves early. Take a look at this pattern on your favorite market and give me your comments.