The ADX is the average of two other indicators Mr. Wilder also developed, the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). As there are many web sites that explain how to calculate these, I will not discuss the calculation here. Most technical trading software makes these indicators available.
The way ADX is calculated, using absolute values and percentages results in answers between 0 and 100. That is, answers are always positive and are less than 100%. In fact, it is quite rare to ever get a reading above 60. So what does the ADX indicator tell you? A reading above 40 tells you that there is a strong trend in place either rising or falling. A reading below 20 tells you there is a weak or no trend present and that you may be in a period of range trading (trading in a range neither going up or down regularly).
With ADX, crossing points are also important. When the readings move above 20, it may indicate that a trend up or down is finally developing and that you may be moving out of the trading range or sideways market. When the reading moves below 40, it shows a weakening trend and may indicate you are about to begin range trading.
So, you can use ADX to confirm that the chart you see really does indicate a trend and also how strong that trend is.
Mr. Wilder built a trading system around the three indicators +DI, -DI and ADX. So they can be used for more than just confirming a trend.
Technical Analysis Principles - Cycle Duration:
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How long are the cycles? That's an important question, and it's going to be a real bear to answer without any charts as visual aids, but I'll do my best. The reason it is such an important question is that all oscillators work best when you use the proper number of bars in their calculation. The correct number of bars is associated with the dominant cycle's duration at the time in question. Some traders seem to be able to find the cycles in price data very easily. Then there are other traders, like me, who have a harder time with this. I'll describe several aids I use in finding cycles.
The first step in determining a cycle duration is to have a good understanding of the time horizon you want to use in your trading. Some traders trade VERY frequently -- often several times a week for each tradeable they are tracking. Others trade only once every several years. It is vital that you know which approach meets YOUR investment or speculative goals, and which approach fits your personality. If you are a frequent trader using daily charts, like me, then you need to be looking for cycles in markets that last from eight to thirteen days. If you are moderately active, you need to be looking for cycles that last from 32 to 52 days. If you are very inactive, you probably ought to be using weekly charts and looking for 26 week cycles and longer.
Try to use the same number of bars on all your charts and train your eyes to "see" the dominant cycle you use in your trading. Remember that there are cycles superimposed on top of cycles in the market. Short cycles are floating on longer cycles. Obviously, their duration is only a fraction of the longer cycles.
The standard deviation envelope tool can help you to "see" cycles. When prices "rub against the bottom" of that kind of envelope, you are near the start of a new cycle with a duration expected to be as long as that for which you calculated your standard deviation of the chart. If the envelope is rising, count bars between the lowest prices attained when prices are "rubbing against the bottom" of the envelope. Cycles are not always easy to see. Standard deviation envelopes can help you identify the cycles when the data is more confusing than not.
Use an envelope calculation duration that is about the length of the cycle you want to trade and look for extreme prices near the edges of the envelopes. Those prices will be the peaks and valleys of the cycle in which you are interested.
The trend channel function is another handy tool to help you find cycles. The first step in using a trend channel, when looking for cycles, is to draw one between two obvious turning points on a chart. Then look at points where the prices touch or get close to the bottom of a rising trend channel or the top of a falling channel. Those are starting points of cycles. Don't use a point like this unless prices have touched the opposite edge of the trend channel since the last similar point was made. Count the number of bars between these points to obtain cycle durations. Do not count a touch point which has not touched the top edge of a channel since its last touch of the bottom edge.
Oscillators can also help you find peaks and valleys in price curves that correspond with the starts of cycles. Use oscillators that are calculated with durations close to the cycle durations which you want to trade. In an upward trend, the valleys in oscillators often correspond with the starts of cycles. In a downward trend, the peaks of oscillators often correspond with the starts of cycles. Use the lowest (or highest) prices obtained near an oscillator bottom (or top) as the exact starts of cycles. Once you train your eyes to "see" the cycles in which you are interested, you can usually pick them up by just looking at a chart and counting bars between valleys in a rising trend and peaks in a falling trend.
Remember that cycles are not always present in prices. To obtain the best estimate of the cycle durations that ARE present, go to the last point on the price chart where the cycles were fairly regular and use cycle duration obtained from THAT period for your PRESENT oscillator calculations.
Posted by: Bob Hansell | March 6, 2006 4:48 PM | Permalink to Comment