Updated: Sep 19, 2020
If there is one thing that a trader would want to know for certain, it would be to pinpoint the bottom or top of a trend. But simple as it sounds, it is easier said than done. Knowing that a certain price wave is completed, or is just a retracement in the larger trend becomes more of an art than a science. In such situations, using multiple sources of confirmation helps to avoid the potential false signals, and preserve our capital for only those situations that provide us with the most favourable risk to reward scenarios.
Keeping that in mind, we will use two very different indicators – the Bollinger Bands and the ADX - to form a system which should help us to “catch a falling knife.” Bollinger Bands is an indicator that allows users to compare volatility and provide a relative definition of high and low.
The indicator consists of three bands which usually to encompasses the majority of price action.
A simple moving average in the middle
An upper band (SMA plus 2 standard deviations)
A lower band (SMA minus 2 standard deviations)
The basic interpretation of Bollinger Bands is that prices tend to stay within the upper and lower band. Because standard deviation is a measure of volatility, Bollinger bands adjust themselves to the market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average). The tightening of the bands is often used by technical traders as an early indication that the volatility is about to increase sharply.
Following are the characteristics of Bollinger Bands.
Sharp price changes tend to occur after the bands tighten, as volatility lessens.
When prices move outside the bands, a continuation of the current trend is implied.
Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.
Based on these, one may go long or buy the market below the lower band while selling short the market above the upper band. However, this can become a dangerous proposition if the market develops a strong trend, and price starts “walking the band” creating new extreme price levels. To counter this disadvantage of the Bollinger Bands, we shall use the ADX indicator.
The ADX indicator measures the strength of the current trend, rising during extreme trending states, and falling as the market retraces in a range-bound state. The ADX line has definite advantages because it filters out a lot of the false oscillator signals which are frequently given early in a move.
The basic characteristics of the ADX are –
When the ADX starts rising from a low level, it signals the beginning of a trend.
The trend is confirmed, when the ADX has risen above the 20-25 value.
When the ADX has reached an overbought level of 40-50 and starts consolidating or turning down, it signals the end of the current trend.
The declining of the ADX signals the consolidation or indecision of the market.
It is this last feature of the ADX that we shall combine along with the Bollinger bands. If we are looking for a downtrend to end, we would look for price to thrust outside the lower Bollinger band, by reaching an extreme oversold level. This by itself may not be the confirmation that the trend has run out of strength. But at this point, if the ADX starts declining from its overbought values, then we have a better probability of the momentum change. The market then reaches “a critical turning point” as the ADX turns back to the downside, while the price falls below the lower Bollinger Band. This indicates that despite the fact that the market has accomplished a relatively oversold state, the internal strength of the trend has weakened and now stands a smaller chance of continuing lower.
Next week we show how this strategy is applied to develop a better trading solution.
Bollinger bands are calculated using standard deviations - usually two - from a 20 period moving average, usually based on the close. These parameters can be adjusted. The bands provide short term limits to price action. Prices falling out of these limits are most likely to pull back towards the median, or middle line, result. Trading approaches are usually based on trading from the bottom to the top of the band. In leveraged equities, such as commodities and futures, the leverage provides ample return, but in equities dollar returns are reduced.
The ADX (Average Directional Index)
This is really a combination of three indicators.
The +DI line cuts in when prices have closed higher. By taking the difference between the previous close and the current, higher, close, it creates a value. This is then recalculated to get an average value over the past (usually) 18 periods. This becomes the +DI line.
The -DI works the same way, but uses the difference between the previous close and the current, lower, close.
The ADX line plots the average of the +DI and the -DI line over (usually) 18 periods. Although we can use just the ADX line, the other two lines help confirm the strength and direction of the trend. The result reveals the strength of the trend, but not its direction. A rising ADX indicates a strong trend. A falling ADX indicates a weak trend.
ADX is not useful in non-trending markets.
Article as published in the Guppytraders.com weekly newsletter, January 27th, 2007 edition.
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