Chris Lee

Trading with a trend lowers risk, and the average directional index, or ADI, is one of the best trend indicators there is. It’s part of the Directional Movement System developed by Welles Wilder to track the commodities market, although it can be applied to any market. The Directional Movement System uses three numbers: The Plus Directional Indicator (+DI), the Minus Directional Indicator (-DI), and the Average Directional Trend (ADX). The +DI and -DI indicators are calculated by comparing the difference between consecutive lows with the difference of two consecutive highs and then smoothing the averages. The ADX is a smoothed average of the difference between +DI and -DI. ADX ranges in value between 0 and 100, and it’s a non-directional indicator. In other words, it measures the strength of a trend whether that trend is upward or downward. Wilder suggested that no trend is present when the values are below 20, while a strong trend is underway when values are at 25 or more. This 5-point gray area gets ticklish for technical traders; many choose to treat 20 as the point at which a trend is identified. When the -DI is above the +DI, the stock is in a downtrend, and when the +DI is above the -DI, it is in an uptrend. In the chart above, when the stock entered a downtrend in October, the ADX gradually increased as the strength of the trend increased. When ADX stays below 25 for an extended period of time, say 25-30 bars, the stock has entered range conditions, moving between support and resistance, until it eventually breaks out into a trend. Keep in mind that ADX was a trading tool designed to work with commodities, which is a volatile market. Although you can use ADX for trading equities and other instruments, it tends to perform better with more volatile stocks. With low volatility stocks, you may need to adjust the parameters away from the 14-period standard indicator recommended by Wilder. There’s also a bit of lag due to the smoothing techniques. Wilder’s trading system using these indicators is pretty simple. The first requirement is an ADX of 25 or higher. A buy signal is generated when the +DI crosses the -DI with a stop placed at the low on the day the buy signal occurred. As long as the low holds, the signal remains in force, even if the directional indicators cross again. Once price drops below the low, the signal is abandoned. A sell signal occurs when -DI crosses +DI within the conditions of ADX => 25. The high on the signal day becomes the stop. In the chart above, after a strong uptrend, there is a reversal with a sell signal generated on October 9; the stop would be set at $225. The trend picked up momentum and the signal held until +DI crossed -DI on January 28th, which signals a buy-to-close and opening a new long position with a stop set at $153. If you consider that the best trades occur in the context of strong trends, and you want to avoid range trading, ADX is a powerful trend indicator, especially combined with EMA or a 50-day SMA to help filter and refine signals.

The Ichimoku cloud is a cluster of technical indicators that traders can use to gauge support and resistance, momentum, and trend direction. It relies on five different calculations, two of which form a “cloud” when plotted on a chart with the space between them shaded in red and green. Although you can get an Ichimoku cloud overly on your charts, it’s still helpful to understand the calculations so you understand their significance, and why the cloud is a useful indicator. Line 1, kenkan sen, or the conversion line = (9 period high + 9 period low) ÷ 2 Line 2, kijun sen, or the baseline = (26 period high + 26 period low) ÷ 2 Line 3, leading span A = (conversion line + baseline) ÷ 2 Line 4, leading span B = (52 period high + 52 period low) ÷ 2 Line 5, chikou span, or lagging span = closing price plotted 26 periods in the past As you’d guess, the conversion line, which is charted in blue, most closely follows price action; it’s the line most sensitive to price movements. The baseline, in red, lags the conversion line, but still tracks price action fairly well. It should be pointed out that those numbers, 9 and 26, are significant; the MACD uses 9- and 26-day moving averages. Leading spans A and B actually form the cloud. The green cloud boundary, tied to the 9- and 26-day periods, is more responsive than the red cloud boundary, which is tied to the 52-day high and low. You can spot trends with the cloud in two ways: When the trend is up, prices are above the cloud. An uptrend produces a green cloud. When the trend is down, prices are below the cloud. A downtrend produces a red cloud. When prices are inside the Ichimoku cloud, the trend is flat. You can also use the cloud to identify support and resistance based on the stock’s price in relation to the cloud, and in fact, the cloud can project support and resistance levels into the future. This is one reason some technical traders prefer the Ichimoku cloud over other indicators. Pairing the Ichimoku cloud with other indicators is helpful in confirming momentum. For example, RSI in combination with the cloud confirms momentum and places movement in a smaller trend within the context of a larger one. In a strong uptrend, the price may dip into the cloud or even fall below it before climbing again. If you looked only at the cloud, you would miss the gathering momentum. For novice traders, the Ichimoku cloud can be busy-looking and intimidating, which is one of its limitations. On the other hand, experienced traders say that it presents well-defined trading signals. As with most indicators, you should choose the ones that work with your own personal trading style. Finally, you should be aware that even though data points are plotted into the future, there is really nothing reliably predictive about the cloud. It is simply plotting future averages.

There are actually three main triangle patterns, which, when interpreted correctly, give traders information about current conditions, future conditions, and volatility. The triangle patterns are symmetrical triangles, ascending triangles, and descending triangles, and each has different applications and implications for trading. Triangles are generally considered continuation patterns, although there are situations in which a symmetrical triangle can also mark a trend reversal. All triangle patterns have at least two highs and two lows that, when connected and extended, form a triangle shape. In a symmetrical triangle, the stock’s up and down price movements are confined to an increasingly narrowing range. Although you can technically draw a triangle with as few as four price swings, most traders wait to see at least three swings up or down to draw the trendline. With an ascending triangle, strength from buyers keeps resistance at essentially the same level during the advance, but each decline is slightly lower, angling the line of support upward to form the apex of the triangle. The downside strength implies an impending upside breakout. In a descending triangle, selling strength draws a constant line of support during each successive decline, while each advance reaches a slightly lower high. This shape suggests a downside breakout. You will usually see a decline in volume as the triangle forms with a corresponding surge in volume once a breakout is identified. If you’re trading a breakout strategy, you can use it with all three triangle patterns. In this strategy, a buy signal occurs when the price moves above the resistance trendline in the triangle, and a sell signal occurs when it declines below the support trendline. Each trade is backed with a stop loss order set just above or below the most recent swing, depending on whether you are long or short. The idea is to capture profit from a breakout, but it’s a good idea to set a profit target so you have a defined exit point on a profitable trade. Another triangle trading strategy is to anticipate the direction of the breakout and enter trades while the price is still inside the pattern. In other words, if you see an ascending triangle pattern forming, you can buy at a better price at the level of support within the triangle pattern, setting a stop at a price just below the triangle at the time of entry. That keeps the trade risk small relative to the potential profit if the breakout occurs as predicted. This strategy only works, however, after the price has touched resistance or support three times. The first two touch points are necessary to draw the triangle; the third sets the price to enter the trade. The one major drawback to trading triangles is the potential for a false breakout. This happens when the price moves out of the triangle, but instead of continuing in either the upward or downward direction, it reverses, and may even break out again on the other side of the triangle. You can sometimes make excellent trades jumping into a false breakout, but again, you should always mitigate risk with a stop. Not all stocks will develop triangle patterns, so you should have other patterns and strategies in your arsenal.

General market wisdom is that using stop losses is highly recommended. There are certain market phenomena such as Flash Crashes and Whipsawing at the time of news announcements which can quite frankly infuriate traders. The fact that these events are hard to manage doesn’t negate the fact that stop losses are a crucial consideration. Stop losses in Options are a made a little more complex by the fact that you apply a stop loss that is triggered by a price change in the option itself, but which is essentially based on a price change in the underlying instrument of which the option is a derivative. Whilst the price of the option tracks the price of the underlier this relationship is not necessarily 100% ‘efficient’ so might not be completely correlated. If you’re using an Index options to hedge an Index position you’d be well to study how the pricing of the Option varies as a function of price changes in the Index. The option might not be providing the hedging that you require. Another key point to consider is that some option strategies, such as a ‘Straddle’ are based on the premise that you hold two option positions which work in combination. In this instance, applying a stop is not required. Your strategy, for example, holding Long Calls and Long Puts (in the same instrument but with different Strike Prices) relies on price movement, and both option positions remaining in place until closed out simultaneously. The main recommendation here is to check that the positions you put on are ‘correct’, a fat-finger error could result in the Straddle being misaligned and leave you open to the risk of losses. The type of stops that can be placed on the option position itself can look like the below screen grab taken from the City Index execution GUI. The ‘Advanced’ function allows the duration of the stop to be adjusted (variations along the lines of GTC) and for Trailing stops to be applied. The functionality is all very similar to that found in other markets. Selling short Calls or Long Puts options involves a lot of risk. For example, selling short Calls leaves you open to unlimited losses as the price of the underlier is technically unlimited to the upside. The related article is a salient reminder on the risks involved with betting against price moving to the upside: httpsss://financial-fraud.blogspot.com/2012/07/porsches-big-squeeze-mother-of-all.html.

The relative strength index, or RSI, is a momentum indicator that tracks the speed and change of price movements. It is an oscillator that moves between 0 and 100, where traditionally a score of 70 indicates a stock is overbought and a score of 30 indicates the asset is oversold. Relative strength index works because it measures an equity’s recent performance against its historical price to identify trends. Before you can understand RSI as a technical trading tool, you need to understand how oscillators work. Oscillators are favored by traders because they are leading indicators that help predict a trend change that hasn’t yet been demonstrated by market movement. When a market trades within a given range, the oscillator smooths out moving averages by following price fluctuations between two values. Oscillators are most useful when the market is trading horizontally within a narrow range as opposed to raging bullish or bearish markets. Oscillators only reach 0 or 100 in strongly trending markets. The math behind the RSI is complex; it is a two-step process that looks at the percentage of loss or gain over a time period, typically 14 days, and then smooths out those values. Many traders argue that a stock is overbought at a reading well below 70, and oversold and values well above 30. In other words, in a generally bearish market, RSI stays between 20 and 60, with resistance occurring around 50, suggesting that a stock reaches overbought territory closer to 60. In a generally bullish market, RSI moves between 40 and 90, with resistance kicking in as it approaches 50, suggesting a stock is in oversold territory when the RSI breaks 60. RSI has its limitations as an indicator, however. It is most reliable when it confirms a long-term trend as opposed to predicting a reversal. Remember, it is a momentum indicator, and as long as momentum remains strong, either upward or downward, RSI could stay in overbought or oversold territory for long periods of time. Using RSI with MACD gives a better overall technical picture of the market. MACD is also a momentum indicator, but it shows the relationship between the two moving averages to give insight into the strength of the momentum. RSI measures price differences in relation to previous highs and lows. As such, the two indicators are often in contradiction. In other words, RSI may indicate the market is overextended, but MACD indicates increasing momentum. MACD crossovers are buy/sell signals; when the red EMA line crosses the black MACD line, that’s a sell signal and when MACD crosses the red EMA, it’s a buy signal. In the chart above, you see in the box to the left that sell signals are present both in RSI and MACD in early September. The stock was overbought, indicating a reversal, which was confirmed with MACD crossover a few days later. To the right, the indicators appear to be in contradiction, with MACD suggesting the breakout was gathering momentum and RSI suggesting the market was overextended. The 15-day moving average is acting as support. Again, as a trader, you shouldn’t rely on a single oscillator or indicator, but instead, pick a few to combine that suit your trading style and use them to confirm signals.

Wedges are price patterns that indicate a reversal is imminent. Unlike symmetrical triangles, which are continuation patterns, wedges will continue in their upward or downward progress until the pattern completes and a breakout occurs in the direction opposite that of the wedge. A downward pointing wedge, known as a falling wedge, is actually a bullish signal. Conversely, an upward pointing wedge, or rising wedge, is a bearish signal. They almost always form within the context of an existing trend, although rarely they occur at the top or bottom of one. A wedge is drawn by connecting multiple high swings and low swings within a trendline; you generally need a minimum of four reversal points to form a wedge, although many go on to have six or more as with a triangle. As the wedge closes, watch for the price to break out of the pattern; this breakout completes the wedge and is a trade signal. On a falling wedge, the breakout is a buy signal, and on a rising wedge, the breakout is a sell signal. Volume should decrease the further you get into the wedge, although this isn’t always the case. Volume should, however, increase on the lows in a bearish wedge and the highs in a bullish wedge. Once the pattern is completed with a breakout, you can expect to see the price move at least as much as the differential at the start of the wedge pattern. In the Johnson & Johnson example above, the difference at the beginning of the pattern was about $10, from $125 to $135. Based on that, you would expect the price to hit at least $145. In this case, it peaked at $149 before the December 2018 correction. Occasionally, a rising or falling wedge can actually be a continuation pattern as opposed to a reversal. These can be more difficult to identify, but they typically occur against the prevailing trend. In other words, you may see a rising wedge within the context of a downtrend or a falling wedge in the context of an uptrend. In these situations, the wedge is a continuation pattern and is not indicative of a reversal, so you have to be cautious when you see a wedge forming against the trend. If you’re trading wedges, you can use them to estimate the size of the breakout based on the height of the pattern, but you should know that the price could run much further depending on the momentum. If you’re short in a falling wedge, you should buy to cover if the price breaks through resistance. The bad thing about trading wedges is that they can last a long, long time, and you can get ahead of yourself thinking it’s bound to end as it narrows into a tighter and tighter price range. Too many novice traders jump the gun anticipating the breakout, when the smarter move would be to wait until the breakout actually occurs to trade.

In technical analysis, a rectangle formation is a price pattern that frames significant support and resistance. The rectangle pattern is from the work of Richard Schabacker, who more or less wrote the bible on technical analysis. It hearkens back to a time when charting was done by hand using graph paper and manual calculations. Where modern technical analysis is based on indicators, technical analysts in the past believed that price patterns would be repeated, and thus were useful in predicting future price movements. Traders recognize rectangles as continuation indicators, signaling a pause in a trend. It’s one of the more easily recognized patterns, formed by two parallel lines connecting highs and lows. Rectangles are also called trading ranges or consolidation zones. The pattern is completed once a breakout has occurred; unfortunately, it isn’t usually possible to determine beforehand which way the breakout will go. Other things to keep in mind with rectangle patterns: Because rectangles are considered continuation indicators, a trend must be present of at least twomonths’ duration. Volume doesn’t follow traditional patterns, as in a symmetric triangle. Volume may decrease as the rectangle develops, especially as price bounces between support and resistance levels, but it rarely increases. When the breakout occurs, however, you should see expansion, which confirms the breakout. A rectangle typically lasts for a period of three weeks to many months. If the pattern is of short duration, it’s generally considered a flag, not a rectangle. When a breakout occurs, it’s typically at least the size of the rectangle pattern. In other words, if the rectangle covers a range between $45 and $50, the breakout will generally be at least $5 in the trending direction. A basic rule of technical analysis applies to rectangle patterns, in that once a line of support or resistance is broken, it will return to the breakout point and the line of support becomes the line of resistance and vice versa. In the example above, you’ll see an established but not too mature downtrend starting in January 2018, and then the price begins to bounce between $135 and $150 for about five months, with low trading volumes. When the breakout occurs, there is a confirmatory spike in volume, and the price pushing against the previous support level, which has now become resistance, before plunging again. You’ll also note that the range of the rectangle, about $15, was actually more than doubled before the trend reversed again. A smaller rectangle pattern can also be seen in April and May 2017. There are two basic strategies if you want to trade on a triangle. The first is to range trade within the triangle, buying at support and selling at resistance, or conversely, shorting at resistance and covering at support. You do need to set tight stops to mitigate risk if you are shorting in case the breakout goes against you. The second is to wait and trade the breakout, which again, is confirmed with an uptick in volume.

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