On Dec. 21, Apple breaks $396, permitting traders to initiate the buy trade. A stop loss can be kept at the lowest low of the previous two days low, which is $387. The trader can ride the rally until the ADX close below 40, as indicated in the chart. As discussed, an ADX below 40 signals a non-trending market. The ADX closed below 40 on April 18, 2012, when traders following this method would have closed the position at $608. In this case, the ADX helped to gain almost $212 points, riding a rally from $396 to $608 in a matter of four months.
Let’s analyze the chart for Caterpillar Inc. (see “Going short,” below) to understand how the ADX generates a short sell trade. On Feb. 7, 2013, Caterpillar made a low of $95.20 and a high of $97.40 when the DI+ line (blue) crossed the DI– line (red) to the downside, signaling a sell setup. Confirmation will come when the extreme point is crossed and sustained. In this case, that point is the Feb. 7 low of $95.20.
On Feb. 19, Caterpillar broke $95.20 and traders following this system were free to initiate the short trade. A good stop loss can be maintained at the high of the previous two days, which is $97.50. As with the long Apple trade, it’s advisable that the trader ride the trade until the ADX closes below 40. The ADX does so on April 23, 2013, when traders would have offset the position at $84. For this trade, traders make almost $9, as the stock moved from $95 to $84 in matter of two months.
The ADX indicator interpretation is fairly straightforward, both as a filter and as a source of signal generation. The DI+ and DI– crossovers are frequent, and technical traders need to filter these signals with complementary analysis. In addition to the extreme point requirement, it’s suggested that traders consider volume-based indicators, basic trend analysis and chart patterns to help distinguish strong crossover signals from weak ones.
Bramesh Bhandari writes at www.bramesh-techanalysis.com and provides online tutoring on technical analysis. He can be reached via e-mail at firstname.lastname@example.org.