Tag: Momentum

Invest Like A Pro! >
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. 

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