Category: Indicators

Invest Like A Pro! > Indicators
Rules for Multiple Time Frames – Rule 3

Rules for Multiple Time Frames – Rule 3

Rule 3 – The trend and momentum of the higher time frame determines the direction and therefore the action taken on the lower time frame.

Using Apple Inc. (AAPL) from 1990-1991, this daily chart shows three arrows. The first points to where the trend on this time frame turns bearish. In this case, we would be looking at the hourly chart (lower time frame) for shorting opportunities while bearish conditions exist on the daily chart. Then, in the 4th quarter of 1990, the up arrow reflects the change in trend using the crossover and slope of the 18 MA and the 40 MA lines.

During this time, using Rule 3, we would only take buy signals on the hourly chart.

I would like to point out that the slope of these two MA lines were rising at about the same rate, almost parallel, with a comfortable distance between them. These are the characteristics of a strong trend. I will discuss momentum indicators later in the book that will help with this determination. However, having the ability to recognize a strong trend and its momentum using only price and MA lines is a clear advantage when you are trying to decide which higher time frame trends to play.

Our odds increase when the higher time frame trend (daily, in this case) and the trigger time frame (hourly) are in agreement. Finally, the last arrow signals the daily trend reversing to the downside again. At this point, we would be down on the hourly chart looking for high probability sell signals.

The higher time frame tells us there is a trend with good momentum and the pullbacks along the way provide an opportunity to find an entry on the trigger time frame. Your odds of finding winning trades, whether long term or short term, will increase significantly by using this rule. There will be many examples throughout the remainder of this manual of how to put this rule into practice.

A Chart is a Chart

A Chart is a Chart

The goal of technical analysis, first, is to define the trend.  I will show a few different methods for defining the trend in the coming pages.  There are countless ways to define a trend but, in my view, keeping it as simple as possible should be the number one goal. 

The second goal is to determine the strength of the trend.  The strength of the trend is defined by its momentum.  In other articles, I show a few different ways to determine the strength of a stock’s trend.  The momentum of a stock can be determined by comparing the most recent price legs, or by using momentum indicators such as MACD, ADX or RSI. 

The final goal is to ascertain how long the trend has been in place.  Knowing the length of the trend is vital because the longer a trend lasts, the higher the probability for a significant correction or a reversal to take place. Below is a stock chart.  I have erased the name, dates and time frames from the chart.  This is just a set of open, high, low, close bars and a simple 18 moving average (magenta) along with a simple 40 moving average (blue).  An 18 simple moving average (MA) takes the last 18 closing prices, adds them together and divides by 18.  When plotted each day, we get a smoothed history of the closing prices over time.  A simple 40 moving average (MA) is plotted the same way only using the past 40 closes in the calculation.  Most investors that have read anything about moving averages are familiar with moving average crossover signals.  Simply put, a crossover signal takes place when the 18 MA line crosses above or below the 40 MA line.  These crossovers can be helpful in defining the trend of the stock.  In addition, the slope of these MA lines, rising or falling, and the degree to which they are rising or falling also help with determining the strength of the trend.  Regardless of whether these bars have developed over minutes or years, the pattern should be read the same way.  Identifiable patterns take place whether these bars are hourly, daily, weekly, or monthly.   The three arrows show where a crossover occurs AND the slope of the MA lines are in agreement with the crossover signal.  This is where the trend is defined as positive or negative based on these parameters.

The slope of the moving averages (18 and 40 MA) and the price structure will change if I switch from a daily chart to a weekly chart, but the process of analysis is identical.

When evaluating a stock chart, the investor must know his or her own risk tolerance in order to determine what time frame is suitable.  Generally, the longer the time frame, the larger the initial risk taken in each investment.   However, the degree of accuracy typically improves.  While minor swings may be manipulated at times, the long-term trend cannot be altered.

ADX Conditions That Help in Stock Selection

ADX Conditions That Help in Stock Selection

Looking at weekly MSFT, I have highlighted 2017.  Notice how price trended starting in late 2016 with the 18-week MA line and the 40-week MA line running almost parallel for the entire year.  ADX started turning up in the beginning of 2017 and rose strongly all year long.  When the ADX line is strong enough to get above the 25 (grey line) level, the stock is in trend mode and it is okay to consider looking for entries on the lower time frame.  The very strongest trends will stay above 25 throughout a pullback or correction phase.  Good ADX strength is what we are looking for on the higher time frame.  We want to see stocks make higher highs in price and confirm it with ADX peaks above 25.  This is a great starting point if you want to use a screening tool to identify potential candidates. 

Another key factor is what the stock was doing prior to the trend starting.  If a stock spends a significant amount of time in a quiet basing phase or a sideways consolidation, the ADX/DI lines will all drop under 25.  If this goes on long enough to form a pattern on the price chart such as an ascending triangle or a rectangle, then the likelihood is that the stock is prepping for a big move in one direction or the other.  MSFT in 2016 shows how this condition can form.  The stock moved sideways for 6 months or so and the ADX lines moved down under 25.  There is

some lag between price action and the ADX indicator.  In fact, as I mentioned earlier, the greater the volatility of the price action, the larger the lag.  Investors need to realize this fact and know that nothing is going to give an earlier signal than price itself.  Every indicator is a derivative of price and therefore will usually take more time to provide the same evidence.  This is the main reason I have continued to repeat myself about learning price first before moving on to indicators.  When you understand price, you can anticipate.  In the case of MSFT, there is no need to wait for ADX to climb above 25 before considering it as a buy because the low ADX base told you a move was coming.  You can already clearly see the price has started to trend nearly 3 months before ADX crossed 25.  Still having ADX and MACD to help confirm or refute the price action are invaluable tools in your arsenal.

A few key aspects to note with ADX: 

  • Periods of low volatility and low ADX tend to be the precursor to big moves.  However, it is best to wait for price to breakout from its range or pattern to avoid long periods of consolidation.
  • Stocks with bullish price trends that have strong ADX readings are ones to monitor on pullbacks/corrections.  On the higher time frame, focus on the stocks in uptrends which are confirming the higher high in price with a strong ADX reading greater than 25, preferably greater than 30.
  • During the pullbacks of these strong uptrends, on the lower time frame, focus on the stocks with weak ADX (negative) readings.  I will give examples to explain this in more detail.

I am going to focus on the last two aspects from above to illustrate how I incorporate ADX into my existing methodology.  Keep in mind that you want to use the indicators to provide different insights rather than necessarily confirming one another.  Waiting for confirmation from each indicator creates too much ambiguity to the signals and makes you question what is taking place.  Not to mention, your entry will be very late waiting for every indicator to confirm.

Instead, I use the ADX to help me to determine WHICH stocks to focus on and I use the MACD to help with the timing of the trigger along with price and the MA lines as previously discussed.

ADX is Non-Directional

ADX is Non-Directional

The interesting and confusing fact about this indicator is that ADX is indifferent as to direction.  The ADX line will rise if there is a strong trend and it does not matter whether that trend is to the upside or to the downside.  It is based on the difference between the two DI lines regardless of which of the two is on top.

There are two weekly charts of Microsoft Corp. (MSFT) above.  ADX is rising in both cases.  On the left, the stock is rising and +DI is separating from -DI and this is causing the ADX (blue) to rise.  On the right, -DI is separating away from +DI and the ADX line is rising. 

This is a powerful indicator because you need real buying power to get it to move.  Once you get used to the fact that rising = strong, ADX can be very helpful in the stock selection process.  Personally, I believe this is the best indicator for determining which stock to play.  If I have 2 choices where the overall price structure is the same and MA lines are generally the same, I will go to ADX to determine which is the stronger trend.  Stocks with high ADX readings tend to move faster and stronger than stocks with low ADX readings.

Using the ADX indicator

Using the ADX indicator

ADX (Average Directional Index) is used to analyze the strength of a trend.  It is a complex indicator with several moving parts.  An in-depth understanding of how to use this indicator will take time.  I am going to provide you with a simple explanation of how it is calculated and how it can be incorporated into what I have already explained. 

In prior articles, the MACD indicator was explained.  It uses closing prices in its calculation.

I bring this up again to make the distinction between MACD and ADX why they are very different and why they can complement one another. 

ADX uses the high/low range to calculate the lines.  The closes play no factor at all in this indicator.  So, MACD uses the closes and ADX uses the range.  This is a critical distinction since the market goes through changes in volatility as much as it goes through changes in trend.  When volatility expands, the MACD carries more weight and as volatility contracts, the ADX indicator increases in its importance.  You can do fine by picking one or the other but each of these indicators provide outstanding signals at times and I believe it is beneficial to understand both.

ADX Calculation

This is the monthly chart of Visa Inc. (V) from the last section.  I have zoomed in on the last few years to show the +DI (Directional Plus) and the -DI (Directional Minus) and how they are derived. 

Simply put, the +DI is the strength of the buyers and the -DI is the strength of the sellers.  These lines are created independent of one another.  Let us start with the buying strength (+DI).  The distance between the high of one bar and the bar before it shows us how much the buyers were will pay over and above the prior session.  The green arrows and green lines on the chart highlight the distance between the highs.  This is Positive Directional Movement (+DI or sometimes called +DM).  As a stock makes higher highs, the +DI gets stronger.

On the selling side (-DI), the distance between the low of one bar and the bar before it shows us how much the sellers were willing to take the price down below its prior session.  The red arrows and red lines on the chart highlight the distance between the lows. As a stock makes lower lows, the -DI increases in strength.   

In ADX, the side with the greatest range wins the bar and that range amount is then added to +DI or -DI.  To create the lines for each, we take a simple average and plot them.

The ADX indicator (blue line) is created by taking the difference between these two lines and then plotting it as a moving average as well. 

Charles Schaap wrote a book called ADXcellence.  This is another outstanding book and it is an in-depth discussion of all aspects of ADX/DI.  I recommend it for anyone who truly wants to understand this indicator and its wide variety of uses.  Linda Raschke also describes her uses of ADX in some of her books, manuals and videos.  Each uses this indicator in a similar fashion with a few modifications. 

Schaap uses a 13 moving average of the DI lines.  Most software packages use 14 by default so not a big difference there.  However, he uses an 8 moving average to create ADX.  Standard packages use 14.  I adopted Schaaps 13, 8 settings in my analysis and interpretation of ADX.  The ADX (13,8) is more responsive to changes in direction than the traditional ADX (14,14) and therefore has more peaks and valleys.  This provides more insight into the strength of the last leg and becomes important in determining the strength of a pullback or rally against the trend.  For our purposes, this information becomes a vital factor. 

Pinch Plays

Pinch Plays

Linda Raschke wrote a book called Street Smarts with Larry Connors.  This is a great book.  One of their signals is called an Anti.  They use a different form of MACD or Stochastic to find this signal.  However, the concept is the same.  We want to find when the Signal line has turned or is trending and the MACD moves counter to it.  It causes the two lines to pinch together for a brief period without causing a crossover.  The weekly chart of Apple Inc.  (AAPL) from 1999 shows back to back Pinch signals

after price emerged out of its base.  Typically, price will pullback 2-3 bars or will drift sideways to alleviate the short term overbought condition.

Sometimes these signals will take place following momentum divergence (discussed next) or in conjunction with divergence patterns.  Once again, the best signals will usually emerge when there are signals from the price structure and the MA lines to confirm. 

The chart of Pepsico Inc. (PEP) from 2018 is above.  Price breaks the trendline (step 1) and then tests (step 2).  This process is also the 40 to 18 bounce pattern discussed prior.  During this rally to the 18 MA line, MACD is unable to regain its Signal line causing a minor pinch to develop.  This gives us enough evidence to sell as soon as 18 MA line is re-broken instead of waiting for step 3 or the break of the 40 MA line.  One of the keys to this signal is watching the price action.  Many times, the MACD line will only tighten to the Signal line slightly so focusing on the counter trend move in price helps this pattern to become easier to recognize.  In addition, the first two pinch plays are the highest probability and then the odds start to drop off somewhat due to the longevity of the trend.  In this example, the reward to risk improves dramatically using this entry trigger rather than waiting. 

Zero Line Reversals

Zero Line Reversals

With the MACD indicator, the zero level is where the fast moving line (12) crosses the slowing moving line (26).  In the chart below, I have added a 12 EMA and 26 EMA to the price chart so you can understand the calculation.  As I have mentioned previously, I do not use MA crossover signals as operative buy/sell signals, but they are useful at helping to define the trend.  So, the zero line (highlighted in lower scale with red horizontal line)

signifies the level where these two EMA lines meet and cross one another.  Oftentimes, good signals take place near this level.  The chart below is the same daily chart of Herbalife (HLF) only with the 18 and 40 simple MA lines back with the price chart. 

Notice that in February, MACD crossed down through the zero line at almost the exact same time that price broke its trendline.  This is the start of the change of trend sequence and the rally back in March sets up the classic sell signal following the 18 and 40 MA line crossover to the downside.  Zero line reversal signals take place when the MACD line itself rallies back toward that key level and turns down.  The is a great example because it shows the power of having confluence amongst the price structure (1-2-3 change in trend), the MA pattern (classic sell signal) and the failure of the MACD line near its zero level.  When you can build a case with independent signals, your odds will improve.

The daily chart of Delek US Holdings Inc. (DK) above shows the zero line reversal in a different form.  This rally toward zero signifies the counter trend rally on this time frame vs the downtrend on the higher time frame (weekly).  Notice the 1-2-3 sequence that takes place as well as the buy signal that fails using the 18 and 40 MA lines. MACD crossing down through its Signal line is the operative sell signal here and gives the investor a great timing tool to use in conjunction with the other indicators.  I cannot stress enough the skill of recognizing the price structure together with the MA setups to give you the understanding of where a stock is situated in its price trend.  Then, adding the MACD will improve the timing and confidence even more.

The chart of Sysco Corp. (SYY) is another example of a zero line reversal which helps with the timing of a lower time frame entry.  The red arrow points out the actual MACD cross of the Signal line following the zero line reversal. 

Using the MACD Indicator

Using the MACD Indicator

MACD stands for moving average convergence divergence.  This indicator has been one of the most popular indicators for the past few decades.  MACD is a momentum indicator and can be useful for determining the strength of a given trend, overbought and oversold conditions as well as imminent reversal areas.  In basic terms, MACD plots the difference between two moving average lines.  The creator of the indicator, Gerald Appel, used exponential moving averages in his calculation.  The popular EMA lines used are 12 (fast) and 26 (slow) and the difference between these lines is displayed as the actual MACD line.  In addition, this indicator employs a Signal line, which is a moving average of the MACD line, in this case a 9 EMA.

I have always used the original MACD settings in my work with clients over the past 30 years.  MACD was the first indicator I used when I started in technical analysis and has continued to play a role in my interpretations of the trend and its strength.  An important factor is that since MACD is based on MA lines, it is calculated using the closing price of a stock.  The high and low range for each bar is completely ignored.  This fact will become more significant when I explain the use of the ADX indicator in the future articles.

If you browse through the example charts in my book, you will notice MACD is in the lower scale on every one of the charts.  There are specific signals and characteristics I look for when using this indicator in conjunction with the 18 MA and 40 MA lines.  I am sure you are wondering how a 12/26 EMA indicator would work with 18/40 SMA lines.  Keep in mind, the idea is to use the methods independently and then look for common ground.  I purposely started with articles related to the price action and trend.  The reason, as I stated earlier, is that you must become proficient at reading price patterns, trends and structure without the use of indicators before moving on.  It is critical that you develop the skill of seeing the trend and change of trend, preferably with only price bars on the chart.  Then, it becomes useful to use indicators to improve and enhance what you are already seeing with the price action.  To repeat, start with price bars, then add MA lines, followed by using the MACD or ADX or both. 

There are specific patterns that develop with MACD that I am going to cover with numerous examples.  The four most prominent signals for my work are zero line reversals, pinch plays, momentum divergence and reverse divergence.

All content is Copyright 2019, Invest Like A Pro, LLC.