Barbara Star – Detecting Trend Direction & Strength

Author: Barbara Star

Starr is a graduate of the California State University, Northridge, from which she earned a degree in journalism. From 1979 to 1988, she was a correspondent for Business Week magazine, covering energy matters. She then worked for the news magazine Jane’s Defence Weekly from 1988 to 1997 covering national security and defense policy before joining ABC News as a producer, covering the Pentagon, for which she won an Emmy Award.[1]

In 2001, Starr joined CNN as the lead Pentagon correspondent, covering national security issues including the wars in Iraq and Afghanistan.

Detecting Trend Direction & Strength

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Traders use technical indicators to recognize market changes.

They look to indicators for signs of price direction, momentum shifts, and market volatility. Among the most sought-after indicators are those that identify price trends. Traditionally, moving averages serve that purpose, but they suffer from whipsaw action during price consolidations. However, there is another approach. This article shows how to combine two popular indicators to help traders detect not only trend direction but also trend strength.

The indicators involved are the average directional index (ADX) and the moving average convergence/divergence (MACD). The ADXfunctions as a trend detector, rising as price strengthens into an identifiable trend and falling when price moves sideways or loses its trending power. ADX values in the 20 to 30 range indicate mild to moderate trending behavior, while values above 30 usually signify a strong trend. Unfortunately, the ADX does not reveal the trend direction. The MACD, on the other hand, indicates price momentum and can also be used to identify price direction as it rises above its trigger line or falls below its zero line.

FIGURE 1: ADX AND MACD WITH AOL TIME WARNER (AOL).

The rising ADX in the upper panel does not differentiate between up- or downtrending price movements. Plotting the MACD just below the ADX makes the trend direction much easier to spot.

THE CONFIRMING PATTERN

Most traders prefer the long side of the market and look for an uptrending market. The confirming pattern identifies exactly that condition. When the ADX and MACD move up in unison, they confirm rising price direction; the Bristol-Myers Squibb Co. (BMY) chart in Figure 2 offers a good example of a confirming pattern. The ADX and MACD rose as price moved up strongly in September to December 2000.

When price changed direction in January 2001, both the ADX and MACD followed suit. The falling ADX was not indicating that a downtrend had begun; merely that it no longer could find a trend. In this example, the MACD showed that price was retracing its prior upward march. But sometimes when both indicators fall, price forms a sideways trading range, rather than the more pronounced downward move seen in this chart.