TRADING BASICS
Combine ADX And MACD
Detecting Trend Direction
And Strength
by Barbara Star, Ph.D.
Using an indicator by itself can reveal a portion of the entire picture.
Combining it with another can reveal more.
Traders use technical indicators to recognize
market changes. They look to indicators for signs of price direction, momentum
shifts, and market volatility. Among the most sought-after indicators are
those that identify price trends. Traditionally, moving averages serve
that purpose, but they suffer from whipsaw action during price consolidations.
However, there is another approach. This article shows how to combine two
popular indicators to help traders detect not only trend direction but
also trend strength.
The indicators involved are the average directional index (ADX) and
the moving average convergence/divergence (MACD). The ADXfunctions as a
trend detector, rising as price strengthens into an identifiable trend
and falling when price moves sideways or loses its trending power. ADX
values in the 20 to 30 range indicate mild to moderate trending behavior,
while values above 30 usually signify a strong trend. Unfortunately, the
ADX does not reveal the trend direction. The MACD, on the other hand, indicates
price momentum and can also be used to identify price direction as it rises
above its trigger line or falls below its zero line.
When both indicators are plotted on the same chart, trend strength and
trend direction become clear. The chart of AOL Time Warner (AOL) in Figure
1 illustrates how the two indicators complement each other. The ADX in
the upper panel rose from April through May 2001, indicating a trending
market. The MACD rose above its dotted trigger line and its zero line,
showing that price direction was up. During July and August the ADX rose
once again, but the MACD was then below its trigger line and its zero line,
showing that a downtrend was in progress.
FIGURE 1: ADX AND MACD WITH AOL TIME WARNER (AOL). The rising ADX in the upper panel does not differentiate between up- or downtrending price movements. Plotting the MACD just below the ADX makes the trend direction much easier to spot.
THE CONFIRMING PATTERN
Most traders prefer the long side of the market and look for an uptrending
market. The confirming pattern identifies exactly that condition. When
the ADX and MACD move up in unison, they confirm rising price direction;
the Bristol-Myers Squibb Co. (BMY) chart in Figure 2 offers a good example
of a confirming pattern. The ADX and MACD rose as price moved up strongly
in September to December 2000.
When price changed direction in January 2001, both the ADX and MACD
followed suit. The falling ADX was not indicating that a downtrend had
begun; merely that it no longer could find a trend. In this example, the
MACD showed that price was retracing its prior upward march. But sometimes
when both indicators fall, price forms a sideways trading range, rather
than the more pronounced downward move seen in this chart.
...Continued in the January 2002 issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the January
2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2001, Technical Analysis, Inc.
