CHARTING PATTERNS
Discern The Differences
ADX Reversal Patterns
by Charles B. Schaap
When is the trend not going to continue? The average directional
movement index can provide you with information you need to differentiate
between the end of a trend, a consolidation, and a reversal.
Recognizing a change of trend is important
for successful trading. The earlier you can enter a new trend, the lower
the risk and the greater the chance for profit. Your trading will become
more effective when you can recognize the end of one trend and the beginning
of another.
MEASURING TREND STRENGTH
Novice traders often make judgmental statements about a stock, statements
like "The stock looks good here" or "The stock is too high and ready to
tank." What does "looking good" or "too high" mean? Instead of thinking
with emotions, your first step in recognizing trend reversals should be
to start observing. You should base your assessment of trend on objective
data, not opinion.
The best indicator for assessing trend strength is average directional
movement index (ADX). ADX, which can be found on most charting programs,
was developed by J. Welles Wilder Jr. In my book ADXcellence, I
discuss new ADX concepts and patterns, two of which I present here.
ADX quantifies trend strength, so you don't have to guess the strength
of a trend or wonder when the trend will set up for a reversal; the ADX
will tell you. The values for ADX range from zero to 100. An ADX value
below 25 means trend strength is weak and can potentially retrace or reverse.
Values over 25 mean the trend is strong and likely to continue.
ADX is based on two other indicators, the positive and negative directional
movement indicators (+DMI, -DMI), which are plotted in the same indicator
window as ADX. The DMI lines confirm trend direction (I say "confirm" because
we always trade price, never indicators). On my charts, I color +DMI green
and -DMI red. When green is above red, the trend is up; when red is above
green, the trend is down. When a trend is strong with ADX above 25, keep
trading in the direction of the trend until price and DMI lines cross and
signal a potential change of direction.
Figure 1 is a weekly chart of the Standard & Poor's 500 at the market
top in early 2000. The 20-week EMA is red and the 50-week EMA is green.
The trend strength was below 25 for a period of nine months prior to the
trend reversal, ample warning that the trend had weakened and might reverse
at any time. When price broke out below the uptrend line, the red (-DMI)
crossed above the green (+DMI), and ADX subsequently rose above 25. This
indicated major new trend strength in the opposite direction.
FIGURE 1: MEASURING TREND STRENGTH. On this weekly chart of the
S&P 500 you see the confirmation of the trend reversal using ADX and
directional movement.
...Continued in the March issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the March 2007
issue of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
Return to March 2007 Contents
