One of the dangers of trading that many traders fail to consider is the problem of dead money. They may spend a great deal of trying to find buy candidates and working to limit the risk of loss. But they may completely forget about the risk of a market that doesn’t move. This can lead to disappointing results and if too many trades are in stocks that don’t move, a trader may never reach their ultimate financial goals.
For traders, money is among their most important resources. Money, or trading capital, is the inventory for their business. Retailers who lack inventory are at risk of going out business and the same is true of traders. But, the similarity goes a little deeper than this. Just like retailers, traders need to turn over their inventory to make money. A store owner makes more money if inventory sits on the shelf an average of week than they do when inventory sits unsold for months. In any business, a low inventory turnover ratio can threaten the existence of the business.
In trading, one of the most common causes of low inventory turnover is a trade that doesn’t move. Even many traders with rules-based trading strategies have never considered what to do in this situation. The position is neither a big win or a big loss and the trader sits patiently waiting for a sell signal as the stock languishes in a trading range. The obvious solution to this to never buy stocks unless they are in strong trends, but the obvious problem with that solution is how to know when stocks are in strong trends. Among the hundreds of technical indicators, few are likely to be the answer to this problem. And traders may not know about these indicators because they are not widely followed.
One of the indicators designed solely to help us avoid stocks in trading ranges is the Average Directional Indicator (ADX). A variation of this indicator is known as the Average Directional Indicator Rating (ADXR). Both tell us whether or not a stock or ETF is trending and both are rather difficult to calculate.
Although you will never have to calculate the indicator because it is found in many programs and is available on a number of web sites, understanding how it is calculated can provide insights into how to use this trading tool. It’s also important to understand trading tools so you, as the trader, can have confidence in their signals.
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There are different methods of calculating the indicator which was first described in New Concepts in Technical Trading Systems, the classic book published by J. Welles Wilder in 1978. This book also introduced indicators including the relative strength index (RSI), true range (TR) and average true range (ATR) to traders.
For this article, we will rely on the five-step process described by Dr. Alexander Elder in his book, The New Trading for a Living. It’s slightly different than Wilder’s and maybe a little easier to calculate even though the process is still more complex than other indicators.
The first step in the process is to identify the degree of directional movement (DM) a stock made for a given day. To find DM, we need to identify how much of the day’s range occurred outside of yesterday’s range. DM will always have a positive value but it will be call -DM if the majority of the day’s range was below the previous day’s trading. The indicator will be called +DM if the majority of trading was above yesterday’s high. A picture can explain the calculation of DM.
The next data point you need is the true range, or TR. TR is also always a positive number and is the largest of:
- The distance from today’s high to today’s low
- The distance from today’s high to yesterday’s close
- The distance from today’s low to yesterday’s close
Daily Directional Indicators (+DI or -DI) are then calculated using the DM and TR:
For each day, the market action will result in either +DM or -DM but not both. On days when there is positive directional movement, -DM is equal to zero. When there is negative directional movement, +DM will be zero.
The next step is to sum +DI and -DI for the past 13 days. These two indicators can then be plotted on a chart and used as a trend following system. When +DI13 (the green line in the chart below) is greater than -DI13 (the red line in the chart below), the stock is in an up trend. A down trend exists when -DI13 is greater than +DI13.
Although this is a complete trading system, the addition of ADX can help improve the potential profits of this strategy.
ADX can be help identify whether or not you should take the trend following signals. The first step is to find DXR is found with the following formula which is the difference between +DI13 and -DI13.
A 13-day moving average of DX provides ADX. When the values are high, which means the distance between positive movement and negative movement in prices is high, the stock is in a strong trend.
Technical analysts usually consider a value of ADX above 25 to be a signal that the stock is in a strong trend. ADX values below 20 show there is no trend in a stock. Values between 20 and 25 are a middle zone where stocks could be watched for a potential signal. ADX tells us only that a trend exists. A value of 40, for example, is high and tells us prices are trending but this indicator doesn’t tell us anything about the direction of the trend. To determine whether the trend is up or down, we need to turn to other indicators. We could use +DI and -DI or a simple moving average strategy or any other trend following indicator.
So far, we have described a great deal about the indicators. Now, we want to turn our attention to how these ideas can be incorporated into a trading strategy.
We started this article by highlighting that dead money, a trade that isn’t working and is allowing limited trading to sit there, dead for all practical purposes, is a potential problem for traders. To help avoid this problem, traders can look at ADX before they even place a trade. If ADX is below 20, the stock is unlikely to be trending and the trade is likely to result in dead money. This indicator can help avoid the problem by avoiding trades in stocks that are not trending.
Of course, some traders can tell whether or not a stock is trending by glancing at a chart. ADX provides a quantified tool for traders who prefer objective measures or for traders uncomfortable with reading charts.
Screeners can also be used to identify trending stocks, requiring stocks to have an ADX reading above 25 or even higher. The higher the ADX, the stronger the trend which means using a cutoff of 30 or 35 could improve results even more.
Trading, like any business, is a difficult task which is why traders should put as many factors as they can on their side. Many investors use value indicators to find potential buys. They might then look for a bullish technical indicator like the stock trading above its 200-day moving average. Adding ADX could limit trades to just the ones most likely to deliver gains and improved performance, which is the goal of any business owner.