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.