Friday, September 23, 2011

Average Directional Movement Index

Lesson 8
Although the average directional movement index (ADX) isn't used as frequently as some of the popular technical indicators, the ADX line has definite advantages because it filters out a lot of the false oscillator signals which are frequently given early in a move.

A longer-term trader can stay with trending positions longer by following the simple guidelines for the ADX line. According to research by computer trading expert Bruce Babcock, a climb by the ADX line above 40 followed by a downturn signals an imminent end to the current trend (whether up or down). When this signal is given, traders should take profits on existing positions. More aggressive traders can use this signal to consider taking positions for a possible move in the opposite direction.

The charts on this page show how the ADX works. The ADX line on the feeder cattle chart gave two signals during the year. The first downturn accurately marked the top in February, and the second downturn above the 40 level signaled a bottom in late summer. Note that the signal in late July was actually more than a month ahead of the actual bottom in September. The ADX warns you of an end to the trend. In this case, it gave you more than a month's warning.

Like the feeder cattle signals, crude oil's ADX gave two signals during the year, one at the summer low and the second at the winter high. Both signals were given by climbing above 40 and turning down.

The ADX signals by feeder cattle and crude oil signaled the end of one trend and the beginning of a new trend. But the ADX is not designed to signal a trend reversal. It only signals the end of the existing trend.  A good example of not signaling a trend reversal is T-Bonds. The end of the strong spring rally was accurately marked by the ADX signal in June. Then T-Bonds consolidated in a coil until the upside breakout in the fall.

An ADX climb above 40 and downturn in November signaled another consolidation.
Usually, a commodity gives no more than a couple ADX signals during a year, unless the market has particularly volatile price action. The ADX is less helpful during sideways markets.

During extended consolidation periods, the ADX line will slip toward 10. When ADX approaches 10, a major move is usually about to take place. But the ADX line doesn't tell you which direction it will go. You have to rely on other indicators for the probable direction of the next move.

In summary, if the market is trending (whether up or down), the ADX line should be rising. During an extended consolidation period, the ADX line will slip toward a low number

Time to give it a try - can you spot the potential trend change as indicated by the ADX at the bottom of this  chart:


The ADX indicator rose above 40 at the end of November - indicating a potential end to the uptrend that began in September. As mentioned in your lesson, it does not indicate which direction the trend will move in next, only that the current trend is most likely coming to an end...
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