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Our objective is to use a combination of Bollinger bands and ADX signals to pinpoint the bottom or top of a trend. 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 basic interpretation of Bollinger Bands is that prices tend to stay within the upper and lower band. Traders 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.
It is this last feature of the ADX that we shall combine along with the Bollinger bands. If we were 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.
Let us observe the use of this strategy on the following chart example.
The very first example (marked as the green circle.1), proves the effectiveness of this technique.
Price had been in a downtrend, and the Bollinger Bands signalled a reversal with the price closing inside the lower band.
By itself, this should have been a good signal to go long. But if we observe the ADX, it had not yet reached the overbought area, indicating that there is still some momentum left in the downtrend.
(The blue horizontal line on the ADX is plotted at the 40 levels, which is normally considered as an over-extended value of the ADX) And surely enough, this turned out to be a minor retracement with price resuming the downtrend.
We had a similar situation (at the blue circle.2) only this time the ADX had crossed over to the extreme overbought zone, and had started retracing down indicating the trend had weakened.
Since this was the required confirmation form the ADX, we would enter a long trade on the price bar which causes the ADX to cross the 40 line to the downside.
The stop should be placed beneath the low of the price bar which breached the lower band, and we set our price objective on the upper band. As it turned out this trade did not give much of a move, as we exited as soon as price reached the upper band but then, neither did it take out our stops.
Similarly at situation (blue circle.3), the breach of the lower band was confirmed by the ADX reaching its overbought level. By following our rules, we had another confirmed long trade.
If we look at the situations (marked as green circles 4 and 5), the breach of the upper bands was followed by a price reversal, but we ignore those trades since the ADX is absolutely at its lower levels and the Bollinger bands are flat, indicating that the market is in a non trending state. In such cases, we do not enter a trade as we do not know when and where the price is going.
The only drawback I have found with this system is that we get into a trade well after the trend has formed, since we are waiting for the ADX to turn from the extreme level. In the process we miss out the initial part of the move. But then, we are entering on a very solid confirmation of the trend, which increases the success percentage of the trade. And a confirmed trade means increase of the capital, however small. So with the proper use of our indicators and a good amount of patience and discipline, we can take advantage of consistent market behaviour and trade successfully.
Indicator Revision
Bollinger Bands
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, February 3rd, 2007 edition.
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