The market rolled over today after making a valiant but ill-fated attempt to follow-through to the upside after Friday’s gains. The Dow Industrials lost almost 127 points to close at 10,066.57. The S&P 500 Index fell 1.29% and the Nasdaq Composite dropped .69%. Continued concerns over Europe’s debt crisis beat out Morgan Stanley’s raising its target price on Apple Inc.
News before the open about the seizure of a Spanish bank tanked financial stocks today. SKF, the leveraged short Financials ETF, rose 5.07%. The U.S. Dollar rose again in reaction to continued pressure on the Euro, so DUG, the leveraged short oil & gas ETF, climbed 4.64%. Silver did well and AGQ bounced back above its 200-day SMA, adding 3.40%. Despite the good news about Apple, SSG, the leveraged short semiconductor ETF, gained 2.91% and is tip-toeing up to its 200-day SMA. Please click on the symbols for details.
Most technical analysts and even some fundamental analysts utilize technical indicators in their evaluation of the market. Who doesn’t look at where the market closed in relation to its 200-day SMA, for example? So why is is that at times certain indicators seem to be very reliable in predicting market action, e.g., finding resistance and support levels, and at other times the same indicators don’t work well at all?
With the exception of volume, technical indicators can be characterized as either trending or non-trending. Examples of the former are moving averages, MACD (Moving Average Convergence/Divergence), and DMI (Directional Movement Indicator). Examples of the latter are stochastic and RSI (Relative Strength Indicator). Another way to describe indicators is to characterize them as either oscillating or non-oscillating.
Trending indicators are more reliable when the ETF is trending. Buying on pullbacks during a trend is a common theme in Dave Landry’s, Larry Connors’, and Cesar Chavez’ swing trading strategies. A pullback to a major moving average like the 50- or 200-day SMA frequently act as as support when the market is rising or resistance when the market is falling. We saw that with the SPY two weeks ago. Please click on the chart below to make it full-screen:
The SPY ran into strong resistance at a confluence of the 50-day SMA and the 20-day EMA.
When the asset is non-trending, i.e., oscillating, it is trading within a range. Buying near the bottom of the range and selling near the top of the range are effective ways to capture a profit. Below is a chart of GLD range-trading in February and March:
So how can you distinguish between when an ETF is trending and non-trending? If it has been trending for some time, that’s easy to see. Dave Landry draws a Big Blue Arrow in the direction of the trend in these cases, and trades in the direction of the trend. But what if the ETF hasn’t been trending very long or you just can’t tell?
ADX to the rescue!
ADX stands for Average Directional Index indicator. The ADX indicator measures the strength of a trend and can be useful to determine if a trend is strong or weak. The indicator is a combination of the positive directional indicator (+DI) and the negative directional indicator (-DI). These three lines make up the Directional Movement Index (DMI).
The +DI tracks the upward trend of the stock, while the -DI tracks the downward trend. ADX combines the two and produces a unified trend strength indicator. High readings indicate a strong trend and low readings indicate a weak trend or lack thereof.
It is very important to note that ADX measures the strength, not the direction, of a trend. You could take two ETF’s moving at the same rate of speed, with one trending higher and the other trending lower, and they will have similar ADX values.
When the ADX is above 30 and rising, the trend is strengthening. When it’s below 25 and falling, the trend is weakening, i.e., becoming non-trending. When ADX is 20 or below, particularly below 15, the stock/index/ETF has “non-trended long enough” and you should anticipate a new trend begining soon. Use other technical indicators and/or chart pattern interpretation to forecast the direction.
When the action is bullish and the ETF is trending higher, +DI appears above -DI on the chart. When the action is bearish and the ETF is trending lower, -DI appears above +DI. When non-trending, the +DI and -DI lines will cross over each other frequently.
So let’s look at the two charts above but with ADX included in the chart. First, SPY when it was trending:
Note how on the days SPY bumped into its moving averages and stalled, ADX was near 30 and continued rising. The SPY was in a strengthening downtrend.
Now the GLD chart with ADX:
Back in late February through late March when GLD was trading in a range, you can see the ADX was very low (below 15). With a low ADX you want to use oscillating indicators like stochastics to identify price levels at where you want to look to buy and sell. I highlighted with yellow circles how the stochastic indicator accurately identified the selling level (March 3 – 5) and the buying levels (March 12 – 15 and 24 – 45).
Remember to use the DMI indicator to determine the direction of the trend. ADX measures strength but not direction; +DI and -DI measure which trend (bullish or bearish) is stronger
When GLD was range-bound, you can see how ADX was very low and the +DI and -DI kept crossing through each other. When GLD broke above the rectangle high in mid-April and ADX started rising, the +DI rose above the -DI and stayed above it until last week:
No indicator works all the time, of course, and they are subject to interpretation. A common mistake made by many newbies to TA (and unfortunately, some experienced technicians as well) is to use the wrong style of indicator at the wrong time, e.g., using trending indicators during non-trending conditions. Then they wonder why the indicator “isn’t working.” Find a few indicators in each style you find useful, e.g., moving averages for trending and RSI for oscillating, and use them in conjunction with the ADX. With practice you should find your “prediction” skills improving and your account balance trending higher.