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CLASSIC TECHNIQUES
Let profits run: “One place that I have found the ADX to be
especially good is when a stock is screaming — really roaring
— and I am getting really nervous because it is just too
strong,” he adds. “I love to take profits on easy money, and
ADX is an objective way of getting through the excitement of
FIGURE 3: SPYDER BASIC INDUSTRIES. The April price breakout caused ADX to rise from
just wanting to reach out there and grab that profit. So if I have a low of 15 to over 50. While the temptation might be to take profits when ADX moves into
a 35 to 50 ADX and a stock that’s up 25% in the last 30 days, my ranges well above 30, sticking with the ascending ADX may prevent an early exit and gain
instinct is to say: ‘It can’t maintain this. Get out and take the extra profits.
profit!’ But staying with ADX will keep me in it.” (See Figure 3.)
“Over the last decade, what is now happening to the
Internet stocks occurred in other sectors. There have been charting screen to call attention to changes in market shifts
rotations into different sectors or industries that have had and market strength. When the ADX is above 30, it turns a
very strong momentum; the biotech stocks did that for a different color than when the ADX is between 20 and 30.
while, the gaming stocks did that as well. I refer to them as the “[Being above 30] signifies to me that there is a strong
tulip sectors†. ADX will keep you in a tulip stock a little trend on the time frame you are looking at. And if the ADX
longer. It probably is one of the best indicators to take the rises high enough, then any reaction should trigger a retest of
emotion out of a really strong stock.” sorts about 80% of the time. It comes from the generic
Rabbitt uses the ADX to signal whether he should be technical analysis principle that momentum precedes price.
trend trading with averages or range trading with RSI and If there is strong-enough momentum, the price extreme is still
Bollinger bands. Others, such as Linda Raschke, take a yet to come,” she opines. (See Figure 4.)
more classical approach. Trading momentum retracements is one of her favorite
strategies. “I like to enter as the price is retracing. For instance,
LINDA RASCHKE if price is in a downtrend and then price starts having a reaction
Linda Raschke, the president of the LBR Group, initially and begins to move up, I will sell while price is moving up
gained recognition for her professional trading prowess in rather than wait for it to top and turn down again,” she says.
Jack Schwager’s The New Market Wizards. Raschke trades
her own funds. She combines classic technical analysis with
tape-reading to trade all futures markets as well as futures
indices and stocks. To learn more about her trading style and
philosophy, visit her Website. (For the URL, see “Related
resources” at the end of this article.)
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if I short it and it’s still a little bit too early, it will still turn and
come down. With experience and timing, you can minimize
the drawdown.”
But, she cautioned, always buy or sell in the direction of the
trend. “People get far too caught up looking for exact price
points. There’s not a perfect way to find the entry,” she points
out. “The moving average is a proxy for the entry window or
zone. Some aggressive traders might use a shorter moving
average length, such as a five-unit or 10 instead of a 20. They
will trade more often, but their net profit may not be as high.
The 20 moving average might miss a few trades, but average
net profit will be higher.”
Raschke has observed that the execution skill in placing a
trade accounts for 50% of any gain or loss. “The degree of FIGURE 5: UPSIDE HOLY GRAIL. This pattern takes advantage of retracements in a trend
hesitancy involved or the finesse in placing the order makes to make short-term trades once the retracement is over and the trend resumes. Here’s both
a big difference. I use market orders because I don’t want to a 20-unit EMA on the price chart and ADX in the lower panel. ADX located a strong trend in
the daily prices of the June 1999 dollar contract. ADX rose throughout February and into
miss the trade. For instance, there is always a 50-cent spread March before it made a peak and rolled over to the downside at point 1 on the price chart.
in the Standard & Poor’s 500, but I would rather pay that than At that point, price had begun to retrace or pull back to its moving average. The expectation
risk losing the trade.” is that price would retest the high that was made at point 1, which it did at price point 2.
Holy Grail: Momentum retracement forms the basis of the other method to trigger an entry,” she advises. “I have never
Holy Grail pattern, one of Raschke’s best-known methods, found an edge trading on the turn up of the ADX unless it is
and ADX plays a key part in setting it up. The trading rules for starting from a very low level. ADX contains too much
the Holy Grail are simple: smoothing, which causes it to lag.”
Using daily data, the frequency of retracement setups on any
1 The 14-unit ADX must be above its 30 level to signify given security may only occur once a quarter. “That’s why I look
that a strong trend is in progress. at several commodities and different time frames. An ADX setup
2 When ADX forms a top and begins to turn down, look would occur more often on a 60-minute chart — maybe three
for a retracement that causes price to move toward its
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appears on Raschke’s screen to signal a potential market
consolidation. “Price bars overlap, which causes ADX to drop
down very low. Whenever there is a lot of price bar overlap,
you start to see a sideways line, such as in classic point-and-
figure charting,” she comments. “Any sideways line will
show up as a classically recognized chart pattern, be it a
rectangle or flag. At that point, you also tend to find price
clustered around the moving averages.” That signifies basing
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action within a trading range from which it is possible to draw
support and resistance lines. FIGURE 7: CHART FORMATION BREAKOUT ON THE DAILY DJIA. In the chart formation
“According to classic technical analysis, the longer price breakout pattern, ADX lays well below its 20 level as it did with the DJIA throughout February
moves sideways, the more likely that the chart pattern will be a 1999 and into March. During that time, price was forming a sideways chart pattern. A
breakout from that pattern occurred as ADX began to rise, indicating the potential for a trend.
reversal pattern rather than a continuation pattern” (Figure 7).
The potential was realized as price soared from 9500 to 11000. The chart formation pattern
Raschke continues: “When ADX moves down that low, is a riskier trade.
you are in a breakout mode; once price breaks out, you could
be in a trend. So, draw your trendline and look for some type
of breakout method. You are probably coming into the end of Ready to respond to what the market shows, Linda Raschke
the consolidation and you could expect that the next price is a tape-reader and a classic technician, but the next ADX
move would be a real reversal. trader focuses on mechanical systems and tends to be more
“But,” she adds, “that isn’t always the case. You can’t comfortable with the raw numbers than with charts.
predict the direction of the breakout. As a trader, I try to be
prepared for a sharp price move in either direction. The CHARLES LEBEAU
sideways breakout (as in Figure 7) tells me that the market is Trader and writer Charles LeBeau has more than 30 years of
ready to pick up momentum again. An early entry means trading experience. He is president of a commodity advisory
more risk because there is less confirmation, but if the trade
is successful, you ultimately could receive a greater reward.” METASTOCK FORMULA
Risk management: Regardless of ADX method used, risk Here’s the MetaStock formula for the average directional
management is extremely important. “After entering the trade, index (ADX) with decimal point included:
the time frame and price volatility determines the appropriate
Periods:=Input(“Time Periods”,1,100,14);
risk I would be taking. On a five-minute chart of the S&P 500,
I wouldn’t want to risk more than five points from where I PlusDM:= If(H>Ref(H,-1) AND L>=Ref(L,-1),H-Ref(H,-1),
entered,” she says. “But the way the S&P has been trading lately, If(H>Ref(H,-1) AND L<Ref(L,-1) AND H-Ref(H,-1)>
if I were trading from a 60-minute bar chart, the more appropriate Ref(L,-1)-L,H-Ref(H,-1),0));
risk might be 10 points.”
The same criteria apply to stock trades. However, a stock trade DIPlus:= 100*Wilders(PlusDM,Periods)/ATR(periods);
may last two days to two weeks, depending on price volatility
and the trading time frame selected (that is, intraday, daily). MinusDM:= If(L<Ref(L,-1) AND H<=Ref(H,-1),Ref(L,-1)-
Raschke handles risk management of the chart formation L, If(H>Ref(H,-1) AND L<Ref(L,-1) AND H-Ref(H,-1)<
Ref(L,-1)-L,Ref(L,-1)-L,0));
breakouts differently. “I find this type of trade the most
difficult because you are still emerging from a low-volatility DIMinus:= 100*Wilders(MinusDM,Periods)/ATR(periods);
environment. It is often difficult to tell where the noise ends
and the real move begins,” she explains. “But the best DIDif:=Abs(DIPlus-DIMinus);
breakouts work right away. Volume confirms a breakout.”
She advises trading with a degree of leverage (that is, the DISum:= DIPlus+DIMinus;
number of contracts used relative to your account size) that
fits the type of chart formation. Use fewer contracts (lower ADXFinal:= 100*Wilders(DIDif/DISum,Periods);
leverage) on a breakout from a rectangle because the stop
ADXFinal
point is farther away, then on a breakout of a flag formation
—Equis International
where the stop point is closer or more well-defined.
and hedge fund company that manages money for both insti-
tutional and individual investors. He is well known for his
work in the development of trading systems. He trades futures
and futures indices. For more information, visit LeBeau’s
Website. (For the URL, see “Related resources” at the end of
this article.)
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David Lucas have developed many systems that can be imple-
mented under almost any type of trading conditions. “ADX
helps me determine which system to execute. For instance,
when ADX indicates there isn’t a trend, that could point to a
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particular system designed to profit from those conditions,” he
explains. “But when ADX tells us there is a strong trend, we FIGURE 8: TRADING THE ADX FROM A LOW LEVEL. LeBeau finds that very good trades
would want to implement another system that would help us often emerge as ADX rises from levels below 20. The June 1999 crude oil chart shows that
stay with the trend.” He often uses 200-day databars or 50 to ADX spent several weeks below its 15 level as crude oil moved down in price. His system
100 weekly data bars to test the system. used the rising ADX in March to trigger an entry that got him into the trade early in what
proved to be a highly profitable trade.
LeBeau looks upon ADX as an indicator, rather than a
system. In his view, none of the parameters are sacred. His use
of ADX to measure trend is based on a combination of fluctu- Rate of change: LeBeau adds a rate of change element to the
ating factors that includes length, level, direction, and his own decision-making process. Rate of change pertains to speed.
added component, rate of change. Normally, it measures the difference between today’s price
and the price x days ago to tell how quickly price is, or has been,
Length: He sometimes adjusts the lookback length of the moving. The greater its speed, the greater its momentum.
indicator so it can provide better and more timely information. However, rather than compare price changes, LeBeau com-
A shorter length speeds up the indicator and makes it more pares ADX values.
sensitive to price movements. “Most of the time, I’m happy “The faster ADX is changing, the stronger the trend, regard-
with the default at 14. But for a faster signal, I have used ADX less of what level ADX is at. You are more likely to be getting
as short as 10 on daily bars and as short as seven on weekly bars. into a trend at a lower level rather than waiting until it reaches
Occasionally, I might optimize the ADX by twos up to 18 just a higher level. For example, if I want ADX one point higher than
to get an idea of whether a short length or longer one works it was yesterday, it’s better if that happens at 12 rather than
better. I’m not looking for any precise number,” he adds. when ADX is at 30. I will be catching the trend earlier,” he
“Optimizing doesn’t make as much difference as you’d concludes.
think. If you want to be more patient and have something more
reliable, you might increase ADX length. Stock traders have Trading rising and declining ADX: LeBeau discovered that
told me they have better results by lengthening it.” ADX can act as both a setup and a trigger in a trending market.
ADX value out to three decimal places and then round it off to
two. (See sidebar for a MetaStock formula of an ADX with
decimal points.)
“The level of ADX tells you where you have been,” LeBeau
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Initially, he used ADX mainly as a setup condition and moving ADX will start to decline showing an absence of trending
average crossovers as a trigger. direction, but the price does not have an absence of direction,
“It was good, but it left a lot on the table. Eventually, we it is moving down!
concluded that ADX was more reliable than the moving aver- “ADX shows that there isn’t a trend or a direction to the
age crossovers. Rather than wait for something else to confirm market and declines because the window of time it’s looking
a move, we were better off going into the trade as soon as ADX at includes both an up period and a down period,” LeBeau
started to rise. So we began using ADX as both a setup condition avers. “We have to wash all that rising data out of the time
and a trigger. It improved our results,” he says. period we are evaluating. I have observed that a 14-unit ADX,
He finds that an ADX rising somewhere between the 10 and with all its smoothing and other components, is really looking
20 level produces very good trades. (See Figure 8.) Trailing at more than 30 days of data. I think we may have a bigger
channel stops — that is, the lowest low of the last x number days window than we realize. If we wait until ADX starts moving up
— helps to preserve profit and limit losses. again indicating a strong down move, most of that move is
When ADX stops rising and begins to decline, look for price over. We wind up going short near the bottom of the move and
moves that are sideways to down. “I use ADX to identify get ourselves in trouble. So you can’t trade every time ADX
sideways markets and then implement a system that buys when rises; you have to take other things into consideration.”
oversold and sell when overbought. The ADX level on the June
Treasury bond triggered one of our ‘buy dips-sell rallies’ SUMMARY
systems. Three highly regarded market professionals approach the
“We have been trading both sides of the market for the past markets from very different perspectives — Charles LeBeau
two to three months now, based on the RSI and ADX saying it’s from systems development; Paul Rabbitt from quantitative
a sideways market. If the RSI goes above 75, I would be looking analysis; and Linda Raschke from tape-reading and classic
to sell; below 25, I would be looking to go long.” LeBeau varies technical analysis. Despite their differing mindsets and ap-
the length of the RSI between four and 20, depending on the proaches, all have found ways to incorporate ADX into their
length of his trading time frame. (See Figure 9.) trading frameworks during both its trending and nontrending
“I’ve also found that some of the best entries occur after a modes. With some examination, there may be a place for the
long price base. The long base brings ADX down to low levels. versatile ADX in your own trading future.
The signals that occur from the low levels lead into a trade
where I can catch that breakout. It is often a highly profitable Barbara Star, Ph.D., university professor and part-time trader,
trade,” he concludes. provides individual instruction and consultation to those inter-
ested in technical analysis. She leads a MetaStock users group
Exits and target objectives: ADX does not trigger an exit for and is a past vice president of the Market Analysts of Southern
LeBeau, but the ADX level does help with setting profit California.
objectives. LeBeau uses the average true range (ATR), a
measure of volatility, to set the actual profit targets. Depending RELATED READING AND RESOURCES
on market conditions, the number of ATRs may range from one Connors, Laurence A., and Linda Bradford Raschke [1995].
to 12. Smaller profits would be expected when ADX is at fairly Street Smarts: High Probability Trading Strategies for the
low levels (nontrending) or at extremely high levels (possible Futures and Equities Markets, M. Gordon Publishing
end of trend). “The juicy part is right in the middle; that gives Group, www.mgordonpub.com
the biggest profits. In one of our S&P systems, when we are at Evens, Stuart [1999]. “Directional Movement,” Technical Analy-
that [profitable] 15-30 midrange, we go for a profit objective sis of STOCKS & COMMODITIES, Volume 17: February.
that is four ATRs. But when we are on the tails of either side, Hartle, Thom [1993]. “The Discerning Trader: Linda Bradford
where the trend is about to end or hasn’t begun yet, we adjust Raschke,” interview, Technical Analysis of STOCKS &
our profit target to one ATR,” LeBeau explains. COMMODITIES, Volume 11: September.
ATR is a moving target. “You might have one target when _____ [1993]. “A Statistical Scholar: Paul Rabbitt Of OpCo,”
you put on the trade and then once you have been in the trade interview, Technical Analysis of STOCKS & COMMODI-
for a few days, the market has changed. Sometimes, a market TIES, Volume 11: May.
gets more volatile and you’ll reach what was the profit target Herera, Sue [1997]. Women Of The Street, John Wiley & Sons.
on the very day that you entered the trade. But now, because the LeBeau, Charles, and David Lucas [1992]. Computer Analy-
ranges are expanding, it’s telling you that you ought to hold out sis Of The Futures Markets, Business One-Irwin.
for a bigger profit so you increase the number of ATRs.” LeBeau, Charles.Internet: http://www.traderclub.com
Rabbitt, Paul. Internet: http://www.rabbittanalytics.com.
Limits of ADX: Every indicator has its weaknesses, and ADX is Raschke, Linda. Internet: http://www.mrci.com/lbr
no exception. “Imagine that we have a nice long base. We jump Schwager, Jack D. [1992]. The New Market Wizards: Con-
on board when ADX starts rising from a low level. We success- versations With America’s Top Traders, HarperBusiness.
fully carry this trade all the way up to a high ADX level,
somewhere above 30, and then the market turns down. The †See Traders’ Glossary for definition S&C