Making Friend with a Trend Using ADX
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June 25, 2007
In the trading business, it''s likely that at some point in time you will ask yourself, “Should I use fundamental analysis or technical analysis? Which is better?” I am not here to explain fundamental analysis or technical analysis, nor am I qualified to tell you which one is better. As a trader, I rely on both types of analyses, although I am principally a technical trader.
In this article, I am simply sharing with you how I make friend with a trend using technical analysis. Some of you may have heard this before: “The trend is your friend until it is the end.” So, how can technical analysis help you identify a trend so that you can ride on it to make profits? What I am going to share with you below is what works for me and it may work for you, but you’ll need to try it out for yourself. It works for me because I like to mix technical analysis with fundamental and time cycle analyses. You should understand that there is no single approach in trading. What you need to do is to learn how to create an edge for yourself by using technical analysis that works for you to improve the odds for success. So, how do I use technical analysis to identify a trend? One of my favorite trend-finding tools is the Average Directional Index [ADX].
You can pick up any book on technical analysis to read the definition of ADX. Put simply, ADX is a technical indicator used to determine the strength of a trend. I like to use 25 as the benchmark. So, here are my rules:
- Any reading below 25 indicates a weak trend;
- Any reading over 25 indicates a strong trend;
- Any reading above 40 indicates that the trend is very strong but traders should be cautious as a reversal of trend may occur anytime.
A Recent Example on Oil Service Holders [OIH] in the US
I have been trading OIH, which is an exchange-traded fund [ETF] that holds a basket of oil drilling companies—for a while. During the past 10 years, a high probability trading pattern in OIH has been identified showing that 9 out of 10 times, OIH went higher from the end of February to end of April. As a trader, what I am interested is to identify high probability trading patterns and apply the appropriate strategy to benefit from such an opportunity to become a profitable trader.
Back in Feb 2007, I took advantage of this high probability trading pattern but at the same time, I waited for a strong trend to develop (remember, I use ADX 25 as the benchmark). As you will see in the OIH daily chart in Figure 1, ADX finally crossed above 25 on April 2.
Figure 1: OIH Daily Chart on Apr 2, 2007
If you were simply buying OIH at $145 on April 2, you should have exited the position on April 30 at $160 as this was the last day of this high probability trading pattern. As you can see in Figure 2, you would have made a 15-point profit, or approximately 10.3% return on your investment in less than a month in OIH. Isn’t that a decent return in a month’s time, simply by using the “buy and hold” strategy?
Figure 2: OIH Daily Chart on Apr 30, 2007
Since OIH is an optionable ETF, options strategists may wish to deploy bullish options strategies such as a long call or a vertical spread to curb the risk dramatically and improve the returns on investment significantly.
Another example: The Straits Times Index [STI] in Singapore
For readers who are more familiar with the Singapore stock market, here is another example showing how you can use ADX to identify a trend and benefit from it. On Oct 3, 2006, STI showed a strong uptrend signal when ADX crossed above 25. Let’s assume that we entered the bullish trade on STI at 2593.
Figure 3: Straits Times Index on Oct 3, 2006
Since then, the ADX has been above 25 but below 40, and it has been a nice run for STI until the mini-crash on Feb 27, 2007. Assuming that due to the crash we changed our bullish trend prognosis and decided to exit the trade on that day at 3111, we would still have made a 518-point profit in 5 months.
Figure 4: Straits Times Index on Feb 27, 2007
So, if you are a trend trader but have yet to incorporate ADX into your trading kit, it may be the right time for you to study ADX and determine if it works for you.
Remember, trade smart and not often!
Good trading!
Jack Wong
Contributing Writer
Optionetics.com ~ Your Options Education Site
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