Stocks & Commodities V. 25:3 (64-67): ADX Reversal Patterns by Charles B.

Schaap

Discern The Differences

ADX Reversal Patterns

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. by Charles B. Schaap ecognizing 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. 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 dont 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
MARIO ZUCCA

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

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Stocks & Commodities V. 25:3 (64-67): ADX Reversal Patterns by Charles B. Schaap CHARTING PATTERNS

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 & Poors 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. The ADX pattern clearly recorded the market top and trend reversal. The first ADX peak of the downtrend was a strong 35 in January, 2001; the second ADX peak was a very strong 55 in April 2001. Based on ADX, the downtrend was getting stronger; it was also stronger than the last ADX values of the uptrend. We can also see the 20-week EMA crossing below the 50-week EMA, which is further evidence of the trend reversal.

($SPX - S&P 500 Index, W) Dynamic, 0:00-24:00 1500.00 1400.00 1300.00 ADX confirms price Trend reversal 1172.51 1140.23 1100.00 1000.00 ADX > 25 Directional movement (13, 8) Red above green 50 25.07 19.41 ADX < 25
Oct Dec Jan Mar Apr 2000 Jun Jul Sep Oct Dec Jan Mar Apr 2001 Jun Jul Aug Oct Nov Jan 2002
eSIGNAL

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.

(ES Z06 - S&P 500 E-Mini Futures - Globex, 5) Dynamic, 10:30 -15:15 134225 134006 End of downtrend Exit short Beginning of uptrend Enter long 133739 133500 133000 132500 132000

TREND MOMENTUM

Directional movement 50 Trend momentum is the velocity of the Low ADX (13, 8) consolidation trend as represented by the price peaks 26.75 and troughs in the ADX. Trend momen20.03 tum can easily be understood by thinking 14.98 0 of driving a car up a steep hill. If you keep 12:00 13:00 14:00 15:00 11:00 12:00 13:00 14:00 15:00 11:00 12:00 13:00 14:00 15:00 11:00 12:00 steady gas pedal pressure, the car would 9/26/06 9/22/06 9/25/06 eventually lose momentum (speed), come FIGURE 2: TREND MOMENTUM. Here you see that the ADX peaks during a downtrend and then weakens. to a stop, and start rolling back downhill. This indicates prices are in a consolidation. Note how after the consolidation the ADX moved back up. Trends behave the same way when steady buying pressure is applied to a stock. The stock will eventually lose momentum and stop rising. When stocks start to roll downhill, we call it a setup and decision. Figure 2 is a five-minute chart of the e-mini S&P. Before trend reversal. Unlike cars, stocks dont have a parking brake, looking at the chart, you must know that ADX is a nondirectional and reversals can sometimes lead to a sudden crash. The end of a trend is not necessarily a reversal. Trends that indicator; the ADX waves appear similar in both uptrends and stall out will frequently go into a period of consolidation. After downtrends. When uptrend strength is strong, ADX rises. When a consolidation, trends may continue or reverse, depending on downtrend strength is strong, ADX rises. Since ADX is the buying and selling pressure. So the first order of business nondirectional, the DMI lines are used to confirm price direction. On the left side of the ADX window you can see high ADX peaks is to exit current positions when a trend ends. Entering a trade in the opposite direction should be treated as a separate trade in a downtrend. When a weakening ADX falls under 25, price

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Stocks & Commodities V. 25:3 (64-67): ADX Reversal Patterns by Charles B. Schaap

usually enters a consolidation period. Any short positions should be covered when the downtrend loses strength and momentum. Following the consolidation price broke out above it and ADX rose back above 25 in the right side of the ADX window. This set up an opportunity for the next trade, a long entry. Traders who assume the end of a trend will automatically set up a reversal trade. However, they are at high risk for getting chopped up and stopped out during consolidation. During a consolidation, price tests the highs and lows and hits resting stop orders. The best risk/reward for going long is to buy near support (pullback) after price makes the first move and breaks out of consolidation. Since we dont know how long a consolidation will last, there is also a time risk when taking a position before price has clearly shown new momentum and chosen a clear direction.

(RS - Reliance Steel & Aluminum Co, D) Dynamic, 0:00 - 24:00

50.00 45.00 40.00 34.966 33.17

Anticlimax

Rising peaks Opposite direction Directional movement (13, 8)

30.00 50 21.17

Declining ADX peaks

19 3 9 17 2006 30 13 Feb 27 13 Mar 27 10 Apr 24 8 May 22 5 12 Jun 26 10 Jul 24 7 Aug 21

0
5 Sep

FIGURE 3: REVERSAL PATTERNS. Note how the peaks become lower and lower from February to May 2006. This suggests a weakening of the trend. Sure enough, the price broke below the trendline after which the ADX rose to levels of 38 and 55. This indicates the price was stronger in the opposite direction.

(ADM - Archer Daniels Midland Co, D) Dynamic, 0:00 - 24:00 While quantifying the peaks is imporConsolidation tant, the ADX line gives a rapid visual Climax 45.00 representation of trend momentum. ADX allows you to see trend reversals before 40.77 they occur due to wave patterns. Reversals are usually a process, and because of 35.00 that you usually get a warning that a trend is about to reverse or consolidate. The exception is the V-type reversal, where 30.00 price makes a rapid reversal without a Higher ADX peak in the direction of the trend period of consolidation. 25.00 One type of trend reversal pattern is Directional the anticlimax. The anticlimax is a gradual 50 movement loss of trend strength as seen by ADX (13, 8) peaks, which become progressively 25.64 19.01 smaller. If the trendline on ADX peaks is 10.85 broken to the upside with prices moving 0 19 3 9 17 30 13 27 13 27 10 24 8 22 5 12 26 10 24 7 21 5 in the opposite direction of the trend, 2006 Feb Mar Apr May Jun Jul Aug Sep then a reversal is probably occurring. In an uptrend, the anticlimax represents FIGURE 4: THE CLIMAX. In May 2006, there was a sudden spike in price. The ADX rose to a value of 44 but overhead supply being slowly eaten up. quickly fell below 25. Prices entered a consolidation zone after that. In a downtrend, the demand is slowly being overcome by supply. With the anticlimax pattern, there is less spiking of price due to less registered new, strong peaks of 38 and 55. This told us price emotional buying/selling at the top/bottom. was stronger in the opposite direction key information to Figure 3 is a daily chart of Reliance Steel & Aluminum distinguish between a trend retracement and a trend reversal. (RS). From February to May 2006, the ADX peaks became ADX not only warns of a trend reversal, it confirms the lower and lower. The last ADX peak of the uptrend was near reversal as well. 25 (weak). A trendline drawn on the ADX peaks shows the gradual loss of trend strength. In May 2006, price broke THE CLIMAX below the price trendline and red (-DMI) crossed above green Another trend reversal pattern is the climax, which is a little (+DMI). ADX broke above the trendline on ADX peaks and harder to recognize. Essentially, it is a relatively lower ADX peak

REVERSAL PATTERNS

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Stocks & Commodities V. 25:3 (64-67): ADX Reversal Patterns by Charles B. Schaap

The average directional movement index is a good indicator to identify the reversals, since its values measure the strength of the trend.

(C Z06 - Corn Futures, 5) Dynamic, 10:30 - 14:15 Climax

2500 2480 2460 2440 2415 2404 2400 2392

in a trend, followed by a higher ADX peak. Directional In an uptrend, the climax is due to (2) movement (1) overhead supply being quickly depleted (13, 8) 2380 by emotional buying at the top. In a 50 downtrend, the climax low is a final flush 33.89 out of the weak-handed long positions. 27.21 The way to tell a climax has occurred is 12.62 to draw a trendline on the ADX peaks. If 0 11:00 12:00 13:00 14:00 11:00 12:00 13:00 14:00 14:00 15:00 13:00 14:00 11:00 24:00 13.00 10.00 the trendline is broken to the upside with 9/07/06 9/06/06 9/05/06 9/01/06 prices moving in the direction of the current trend, there is likely a climax FIGURE 5: CLIMAX TO REVERSAL. On September 1, 2006, ADX made a lower high. The next morning corn occurring. Traders should take note and spiked but it was followed by a lower high on the next swing up. This indicated that the breakout was not quickly look to exit (partial or full) posi- proceeding into an uptrend. Note how the price of corn broke below the trendline and fell rather quickly. tions. Then let the price action settle out before getting a new read on the trend using ADX and DMI day, prices fell into a downtrend after crossing the price signals. trendline. The downtrend was confirmed by red (-DMI) Figure 4 is a daily chart of Archer Daniels Midland (ADM), crossing above green and ADX rising above 25 (2). which climaxed in May 2006. The ADX peak in March was lower than the peak in February, and the peak in April was REVERSALS OF OPINION lower than the peak in March. But in May the stock made a Trend reversals are a process that should be recognized, not sudden spike in price, and ADX broke up through the trendline randomly predicted. A top does not necessarily mean a short on ADX peaks; ADX rose to a value of 44, which is very strong entry. Similarly, a bottom doesnt mean you should enter a and notably stronger than the ADX peak that preceded it. long position. When traders try to pick tops and bottoms, they After the climax, the ADX fell under 25 (weakness) and unknowingly provide fuel to further the current trend. In an price entered a consolidation period. It was not the time to uptrend, early shorts that are forced to cover often spark trend assume a trend reversal and go short. When a climax is climaxes. In a downtrend, running the stops on early longs recognized, take partial or full profits and follow the subse- sets off the final capitulation. quent price action for new signals. The best time for you to place a trade would be after the You can also see the importance of observing price and trend reverses. Obviously, this would be in the opposite ADX following a climax in order to get a new read on price direction of the trend. The ADX is a good indicator to identify action in this case, price spent months establishing a new the reversals, since its values measure the strength of the supply/demand equilibrium. This was not a time to have trend. This helps to make your trading more objective, hence money at risk. After a consolidation period, price will eventu- eliminating unwanted emotions that could influence your ally break out and trend up or down. That will be the time to trading decisions. consider risking our capital again. In contrast, some climaxes do not consolidate; instead, they Charles B. Schaap is an active trader and hedge fund stratmake an immediate trend reversal. In Figure 5, the five- egist and a director of the Hedge Fund Association and a minute corn futures are an example of a climax leading to a speaker at the International Traders Expo. His educational reversal rather than a consolidation. ADX made a lower high site is www.adxcellence.com. (below 25) on September 1, 2006, which means the trend was weak. The next morning, corn spiked up in price, but the new RELATED READING high was followed by a lower high on the next swing up. This Schaap, Charles B. [2005]. ADXcellence: Power Trend Stratwas a warning that the breakout was not proceeding into an egies, StockMarketStore.com. uptrend as would be expected. Wilder, J. Welles, Jr. [1978]. New Concepts In Technical The ADX crossed the trendline on ADX peaks at (1), and Trading Systems, Trend Research. S&C this represents the climax ADX high. During the rest of the See Traders Glossary for definition Copyright (c) Technical Analysis Inc.