Last week the measures used to construct the Average Directional Index [ADX] from J. Welles Wilder Jr. were displayed in different combinations to help provide insight to the ADX. This smoothed directional movement indicator is unique and can be useful when added to other types of indicators or combined with the measures used to construct it. Please see articles from Dec 1^st or 8^th for construction details.

This week movement of all three measures will be explored, including:

• Positive directional movement [+DI]
• Negative directional movement [–DI]
• Average Directional Index [ADX]

 Current conditions will also be assessed.

More information on +DI, –DI and ADX is available in the Directional Movement section of Wilder’s 1978 book, “New Concepts in Technical Trading Systems.” Another resource available to traders is the Help menu item on many charting packages.

ADX Readings

Summarizing the ADX tool, the following information is taken from an Analytical Toolbox article dated 27 September 2007, titled “Applying ADX Tools”, and has been slightly edited.

“ … Key areas of movement for the ADX are 20 and 40, with readings below 20 suggesting a weak/no trend and readings above 40 suggesting a strong trend. The ADX should be used in conjunction with other technical tools. Some general guidelines for the ADX movement are summarized here:

Table 1 ADX Summary of Readings

A rising ADX signals a trending period, either upward or downward, a divergent ADX line is one that is falling while price is rising or declining.”

Chart Specifications

Figures 1 – 4 display weekly and daily line charts for GLD and SPY, which are exchange-traded fund [ETF] proxies for gold and the US equities markets. Since there is a good deal of information the chart, the indicator list that follows provides the reasoning for each. The numbers in parenthesis provide setting values, when applicable.

Trend

• Simple Moving Average [SMA]: Intermediate-term (10-week), short-term (20-day)
• Linear Regression Channels: Standard trend tool, more subjective than SMAs
• ADX and +DI or –DI: DI displayed based on direction of objective SMA
• Relative Strength Index [RSI]: Cardwell’s bullish/bearish ranges as trend identifier (14-period)

Momentum

• RSI: Readers may want to consider the more traditional application of RSI

Volume

• Accumulation/Distribution [A/D]: Chaiken’s volume indicator with trendlines

There are multiple trend tools including those that are more versus less subjective. The main goal here is to compare ADX, +DI and –DI to other more commonly used indicators. When viewing the charts look at the direction of the regression channel, SMAs and +/– DI to assess trend direction and the rate of ascent/descent of the SMAs and ADX movement to assess trend strength.

Figure 1 GLD Weekly Line Chart with Trend, Momentum & Volume Indicators

GLD closed the week of 12/16/11 right at the lower regression channel line. This channel was constructed with approximately six months of weekly data that was extended forward and tracks the long-term bullish move for the ETF. Although the current intermediate-term trend is moderately downward [SMA], the potential for:

• Price support at a long-term trend line
• RSI support at 40, keeping it within a bullish range and
• A/D support at a long-term trendline

All seem to favor a reversal at this point.

In terms of ADX and –DI, the strong long-term uptrend signaled by ProfitSource has subsided; however, ADX is still indicating a trending market (below 40, declining). Since ADX is diverging from the long-term trend it is weakening. Although the major trend can remain on track at this point, the strong upward movement of –DI is providing a warning. A downturn in this measure seems to favor support for the indicators mentioned previously while continued movement upward increases the chance for failure of those support areas.

Figure 2 GLD Daily Line Chart with Trend, Momentum & Volume Indicators

In the shorter-term, GLD slightly pierced the regression channel and its trend is more clearly bearish. RSI has moved below the 40 level and is coming into resistance at both its 9-day SMA and 40. The A/D is also declining and has a little bit further to go before it tests resistance.

In terms of the ADX and –DI, we have a bearish trend that is strengthening (above 20 and rising). –DI has started to decline and needs to continue this decline for the bounce to carry into a reversal. These chart views of GLD provide a good example of how different time intervals interact; while the longer-term trend is considered stronger than the intermediate term-trend, which is stronger than the shorter-term trend, changes to both can evolve from changes in the short-term. If the shorter-term move is simply a bounce the longer, stronger trends are at risk. If the move upward carries, the shorter-term trend can simply be deemed noise.

Figure 3 SPY Weekly Line Chart with Trend, Momentum & Volume Indicators

SPY has once again moved below its long-term upward trending regression channel constructed from one year’s worth of weekly data and extended forward (7/3/09 – 7/2/10). However the intermediate-term trend remains bullish and RSI remains in a transitional range (between 40 and 60). Volume is sending a warning via the potential resistance line which still needs to be confirmed.

In terms of A/D and +DI, the long-term trend is once again sideways or trendless (below 20, falling). This is a significant warning for the long-term bull, with both moves below 20 since March 2009 occurring since June of this year. It does not mean that the long-term trend is bearish, but it is minimally pausing. +DI has been strengthening since October as A/D weakens and both can be monitored with RSI ranges to assess whether the market is favoring a long-term trend reversal or simply a pause in the months ahead.

Figure 4 SPY Daily Line Chart with Trend, Momentum & Volume Indicators

The shorter-term trend for SPY is bearish (downward trending 20-day SMA); however it also can be deemed a trend in transition (RSI between 40 and 60). Volume is confirming the trend with a downward trending A/D line.

ADX and –DI may provide the most immediate insight in Figure 4. The intermediate-term trend is indicated as sideways (last trend falling and below 20); however, the upward move in –DI seems to be subsiding. Readers may want to add +DI to their chart view and monitor A/D, RSI and both DIs to assess SPY’s next short-term trend.

Wilder, J.W. (1978). New Concepts in Technical Trading Systems. Winston-Salem, NC: Hunter Publishing Company.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

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