Articles Library | Technical Analysis Articles | Written by Chuck LeBeau | We have often described how the ADX (J. Welles Wilder's AverageDirectional Index) can be a useful tool for measuring the strength oftrends. (Please review: Contradictions in using ADX and ADX Has it'sLimitations if you are not familiar with our recommended use of ADX.)To briefly summarize our previous advice, we have found that when theADX begins to rise it is telling us that a strong trend is developing.We have often described how the ADX (J. Welles Wilder's AverageDirectional Index) can be a useful tool for measuring the strength oftrends. (Please review: Contradictions in using ADX and ADX Has it'sLimitations if you are not familiar with our recommended use of ADX.)To briefly summarize our previous advice, we have found that when theADX begins to rise it is telling us that a strong trend is developing.A rising ADX has proven to be a particularly reliable indicator after amarket has been going sideways for a while and then begins to trend.For best results, the ADX should begin its rise from a low level (lessthan 15 or 20) because the low level of the ADX indicates that asideways basing pattern has been formed. Most of our applications ofthe ADX strategy have been predicated on finding these highlyprofitable patterns where a trend suddenly emerges after an extendedsideways period.
Unfortunately not all trends begin with a sideways pattern. Thereare many V tops and V bottoms that our rising ADX strategy fails tocapture. In a V pattern the ADX rises and then peaks out and declines.The ADX does not begin rising again in time to catch the change indirection in a timely fashion. By the time the ADX falls and thenbegins to rise again a major portion of the new trend will have alreadybeen completed. As we have pointed out in our previous Bulletins, anyentry on a rising ADX that was not preceded by an extensive sidewaysperiod is not a very reliable pattern.
Recently in our research on using the ADX for trading stocks we haveobserved another ADX pattern that we believe shows great promise. Thisnew ADX pattern signals very timely entries that allow us to profitfrom possible tops and bottoms that are V shaped.
Here is how these V shaped top and bottom patterns can easily be recognized:

1. Make sure that your plot of the ADX also includes the plotof the Plus DI and the Minus DI. The pattern begins when the ADX isabove both the Plus DI and the Minus DI. Most often when the ADX isabove both the Plus and Minus DI the ADX will be at a high level,perhaps greater than 30 or 35. The high level of the ADX indicates thatthe previous trend was a very strong one. Now we are going to try andcatch the reversal of that strong trend.
2. With the ADX ata high level and declining, look for a crossing of the Plus DI andMinus DI. If the Minus DI crosses above the Plus DI it indicates that astrong up market has ended and weakness has set in. If the Plus DIcrosses above the Minus DI it indicates that a strong downtrend hasended and a new uptrend can be expected.
3. These reversalpatterns should be entered only as the market moves in the newdirection. (We suggest that you use stops for entry triggers.) Once youhave entered the trade you should expect a substantial move in the newdirection.
4. Be sure to use a stop loss at the recent lowor high of the previous trend. Be willing to make more than one attemptto catch the new trend. (Sometimes the Plus and Minus DI will crossback and forth more than once before the new trend emerges.)

We have found that this simple pattern identifies major changes indirection in almost any market. However you should be aware that thechange of direction pattern we have described is not as reliable as thetypical rising ADX pattern that starts with a basing action. Howeverthe trades that do work are exceptionally profitable and we know of noother method that is as timely at catching major changes in direction.Most traders take a great deal of personal satisfaction in quicklyrecognizing major changes in direction. This simple entry method canproduce some truly outstanding trades and provides a welcome changefrom typical trend following strategies.
Our Phoenix Bond system uses this technique to identify majorbottoms in the bond market. The same system also spots bottoms inindividual stocks. To catch major tops we simply reverse the logic.Just put up some charts with the ADX and look for the pattern we havedescribed in this Bulletin. We think you will be very surprised at itsaccuracy. Give us your comments and observations on the Forum.
Good luck and good trading.
by Chuck LeBeau