THE NEW TRADING OF A LIVING- THE DIRECTIONAL SYSTEM
The Directional system is a trend-following method developed by J. Welles Wilder, Jr., in the mid-1970s and modified by several analysts. It identifies trends and shows when a trend is moving fast enough to make it worth following. It helps traders to profit by taking chunks out of the middle of important trends.
How to Construct the Directional System
Directional Movement is defined as the portion of today’s range that is outside of the previous day’s range. The Directional system checks whether today’s range extends above or below the previous day’s range and averages that data over a period of time. These complex calculations are best performed on a computer. The Directional system is included in most programs for technical analysis.
1. Identify “Directional Movement” (DM) by comparing today’s high-low range with yesterday’s high-low range. Directional Movement is the largest part of today’s range outside of yesterday’s range. There are four types of DM. DM is always a positive number (+DM and −DM refer simply to movement above or below yesterday’s range).
2. Identify the “True Range” (TR) of the market you analyze. TR is always a positive number, the largest of the following three:
a. The distance from today’s high to today’s low
b. The distance from today’s high to yesterday’s close
c. The distance from today’s low to yesterday’s close
3. Calculate daily Directional Indicators (+DI and −DI). They allow you to compare different markets by expressing their directional movement as a percentage of each market’s true range. Each DI is a positive number: +DI equals zero on a day with no directional movement up; −DI equals zero on a day with no directional movement down.
4. Calculate smoothed Directional Lines (+DI13 and −DI13). Smooth +DI and −DI are created with moving averages. Most software packages allow you to pick any period for smoothing, such as a 13-day moving average. You get two indicator lines: smoothed Positive and Negative Directional lines, +DI13 and −DI13. Both numbers are positive. They are usually plotted in different colors.
The relationship between Positive and Negative lines identifies trends. When +DI13 is on top, it shows that the trend is up, and when −DI13 is on top, it shows that the trend is down. The crossovers of +DI13 and −DI13 give buy and sell signals.
5. Calculate the Average Directional Indicator (ADX). This unique component of the Directional system shows when a trend is worth following. ADX measures the spread between Directional Lines +DI13 and −DI13. It is calculated in two steps:
a. Calculate the daily Directional Indicator DX:
For example, if +DI13 = 34 and −DI13 = 18, then,
b. Calculate the Average Directional Indicator ADX by smoothing DX with a moving average, such as a 13-day EMA.
During a persistent trend, the spread between two smoothed Directional lines increases, and ADX rises. ADX declines when a trend reverses or when a market enters a trading range. It pays to use trend-following methods only when ADX is rising.
The Directional system tracks changes in mass bullishness and bearishness by measuring the capacity of bulls and bears to move prices outside of the previous day’s range. If today’s high is above yesterday’s high, it shows that the market crowd is more bullish. If today’s low is below yesterday’s low, it shows that the market crowd is more bearish.
The relative positions of Directional lines identify trends. When the Positive Directional line is above the Negative Directional line, it shows that bullish tradersdominate the market. When the Negative Directional line rises above the Positive Directional line, it shows that bearish traders are stronger. It pays to trade with the upper Directional line.
The Average Directional Indicator (ADX) rises when the spread between Directional lines increases. This shows that market leaders, for example bulls in a rising market, are becoming stronger, the losers weaker, and the trend is likely to continue.
ADX declines when the spread between Directional lines narrows down. This shows that the dominant market group is losing its strength, while the underdogs are gaining. It suggests that the market is in turmoil, and it’s better not to use trend-following methods.
FIGURE ANV daily, 22-day EMA, Directional System (13).
- Trade only from the long side when the positive Directional line is above the negative one. Trade only from the short side when the negative Directional line is above the positive one. The best time to trade is when the ADX is rising, showing that the dominant group is getting stronger.
- When ADX declines, it shows that the market is becoming less directional. There are likely to be many whipsaws. When ADX points down, it is better not to use a trend-following method.
- When ADX falls below both Directional lines, it identifies a flat, sleepy market. Do not use a trend-following system but get ready to trade, because major trends emerge from such lulls.
- The single best signal of the Directional system comes after ADX falls below both Directional lines. The longer it stays there, the stronger the base for the next move. When ADX rallies from below both Directional lines, it shows that the market is waking up from a lull. When ADX rises by four steps (i.e., from 9 to 13) from its lowest point below both Directional lines, it “rings a bell” on a new trend. It shows that a new bull market or bear market is being born, depending on what Directional line is on top.
- When ADX rallies above both Directional lines, it identifies an overheated market. When ADX turns down from above both Directional lines, it shows that the major trend has stumbled. It is a good time to take profits on a directional trade. If you trade large positions, you definitely want to take partial profits.
Market indicators give hard signals and soft signals. For example, when a moving average changes direction, it is a hard signal. A downturn of ADX is a soft signal. Once you see ADX turn down, you ought to be very, very careful about adding to positions. You should start taking profits, reducing positions, and looking to get out.
Average True Range—Help from Volatility
Average True Range (ATR) is an indicator that averages True Ranges (described in "How to Construct the Directional System" above) over a selected period of time, such as 13 days. Since volatility is a key factor in trading, you can track it by plotting a set of ATR lines above and below a moving average. They will help you visualize current volatility and you can use that for decision making.
Kerry Lovvorn likes to plot three sets of lines around a moving average: at one, two, and three ATRs above and below an EMA. These can be used for setting up entry points and stops, as well as profit targets.
Entries On moving averages, we saw that it was a good idea to buy below value—below the EMA. But how far below? Normal pullbacks tend to bottom out near the minus one ATR.
Stops You want your stop to be at least one ATR away from your entry. Anything less than that would place your stop within the zone of normal market noise, making it likely to be hit by a random short-term move. Placing your stop further away makes it more likely that only a real reversal can hit your stop.
FIGURE LULU daily, 21 EMA, volume with 8 EMA, ATR channels.
It is highly unusual for any market to trade outside of three ATRs—three times average true range—for a long time. Those tend to be the extreme moves. Wheneveryou see a market trade outside of its three ATRs, either up or down, it is reasonable to expect a pullback.
ATR channels work not only with prices. We can also use them to bracket technical indicators to help identify the extreme levels where trends are likely to reverse. I use ATR channels on the weekly charts of Force Index.
While trend-following indicators, such as MACD Lines or Directional system, help identify trends, oscillators help catch turning points. Whenever masses of traders become gripped by greed or fear, they surge but after a while their intensity fizzles out. Oscillators measure the speed of any surge and show when its momentum is starting to break.
Oscillators identify emotional extremes of market crowds. They allow you to find unsustainable levels of optimism and pessimism. Professionals tend to fade those extremes. They bet against deviations and for a return to normalcy. When the market rises and the crowd gets up on its hind legs and roars from greed, professionals get ready to sell short. They get ready to buy when the market falls and the crowd howls in fear. Oscillators help us time those trades.
Overbought and Oversold
Overbought means a market is too high and ready to turn down. An oscillator becomes overbought when it reaches a high level associated with tops in the past. Oversold means a market is too low and ready to turn up. An oscillator becomes oversold when it reaches a low level associated with bottoms in the past.
Be sure to remember that those aren’t absolute levels. An oscillator can stay overbought for weeks when a new strong uptrend begins, giving premature sell signals. It can stay oversold for weeks in a steep downtrend, giving premature buy signals. Knowing when to use oscillators and when to rely on trend-following indicators is a hallmark of a mature analyst.
We can mark overbought and oversold oscillator levels by horizontal reference lines. Place those lines so that they cut across only the highest peaks and the lowest valleys of that oscillator for the past six months. The proper way to draw those lines is to place them so that an oscillator spends only about 5 percent of its time beyond each line. Readjust these lines once every three months.
When an oscillator rises or falls beyond its reference line, it helps identify an unsustainable extreme, likely to precede a top or a bottom. Oscillators work spectacularly well in trading ranges, but they give premature and dangerous signals when a new trend erupts from a range.
We’ve already reviewed one important oscillator—MACD-Histogram. We looked at it “ahead of schedule” because it’s derived from a trend-following indicator, MACD Lines. We’ll now explore very popular oscillators: Stochastic and Relative Strength Index (RSI).
Stochastic is an oscillator popularized by the late George Lane. It’s now included in many software programs and widely used by computerized traders. Stochastic tracks the relationship of each closing price to the recent high-low range. It consists of two lines: a fast line called %K and a slow line called %D.
1. The first step in calculating Stochastic is to obtain “raw Stochastic” or %K:
where Ctod = today’s close.
Ln = the lowest point for the selected number of days.
Hn = the highest point for the selected number of days.
n = the number of days for Stochastic, selected by the trader.
The standard width of Stochastic’s time window is 5 days, although some traders use higher values. A narrow window helps catch more turning points, but a wider window helps identify more important turning points.
2. The second step is to obtain %D. It is done by smoothing %K—usually over a three-day period. It can be done in several ways, such as:
There are two ways to plot Stochastic—Fast and Slow. Fast Stochastic consists of two lines—%K and %D—plotted on the same chart. It’s very sensitive but leads to many whipsaws. Many traders prefer to use Slow Stochastic, adding an extra layer of smoothing. The %D of Fast Stochastic becomes the %K of Slow Stochastic and is smoothed by repeating step 2 to obtain %D of Slow Stochastic. Slow Stochastic does a better job of filtering out market noise and leads to fewer whipsaws.
Stochastic is designed to fluctuate between 0 and 100. Reference lines are usually drawn at 20 percent and 80 percent levels to mark overbought and oversold areas.
Each price is the consensus of value of all market participants at the moment of transaction. Daily closing prices are important because the settlement of trading accounts depends on them. The high of any period marks the maximum power of bulls during that time. The low of that period shows the maximum power of bears during that time.
Stochastic measures the capacity of bulls or bears to close the market near the upper or lower edge of the recent range. When prices rally, markets tend to close near the high. If bulls can lift prices during the day but can’t close them near the top, Stochastic turns down. It shows that bulls are weaker than they appear and gives a sell signal.
Daily closes tend to occur near the lows in downtrends. When a bar closes near its high, it shows that bears can only push prices down during the day but cannot hold them down. An upturn of Stochastic shows that bears are weaker than they appear and flashes a buy signal.
FIGURE CVX daily, 26-day EMA. 5-day Slow Stochastic.
Stochastic shows when bulls or bears become stronger or weaker. This information helps decide whether bulls or bears are likely to win the current fight. It pays to trade with winners and against losers.
Stochastic gives three types of trading signals, listed here in the order of importance: divergences, the level of Stochastic lines, and their direction.
The most powerful buy and sell signals of Stochastic are given by divergences between this indicator and prices.
- A bullish divergence occurs when prices fall to a new low, but Stochastic traces a higher bottom than during its previous decline. It shows that bears are losing strength and prices are falling out of inertia. As soon as Stochastic turns up from its second bottom, it gives a strong buy signal: go long and place a protective stop below the latest low in the market. The best buy signals occur when the first bottom is below the lower reference line and the second above it.
- A bearish divergence occurs when prices rally to a new high, but Stochastic traces a lower top than during its previous rally. It shows that bulls are becoming weaker and prices are rising out of inertia. As soon as Stochastic turns down from the second top, it gives a sell signal: go short and place a protective stop above the latest price peak. The best sell signals occur when the first top is above the upper reference line and the second below.
Overbought and Oversold
When Stochastic rallies above its upper reference line, it shows that the market is overbought. It means that a stock or even the entire market is unusually high and ready to turn down. When Stochastic falls below its lower reference line, it shows that a stock or even the entire market is oversold: too low and ready to turn up.
These signals work fine during trading ranges but not when a market develops a trend. In uptrends, Stochastic quickly becomes overbought and keeps giving sell signals while the market rallies. In downtrends, it quickly becomes oversold and keeps giving premature buy signals. It pays to combine Stochastic with a long-term trend-following indicator. The Triple Screen trading system allows traders to take buy signals from daily Stochastic only when the weekly trend is up. When the weekly trend is down, it allows traders to take only sell signals from daily Stochastic.
1. When you identify an uptrend on a weekly chart, wait for daily Stochastic lines to decline below their lower reference line. Then, without waiting for their crossover or an upturn, place a buy order above the high of the latest price bar. Once you are long, place a protective stop below the low of the trade day or the previous day, whichever is lower.
The shape of Stochastic’s bottom often indicates whether a rally is likely to be strong or weak. If the bottom is narrow and shallow, it shows that bears are weak and the rally is likely to be strong. If it is deep and wide, it shows that bears are strong and the rally is likely to be weak. It is better to take only strong buy signals.
2. When you identify a downtrend on a weekly chart, wait for daily Stochastic lines to rally above their upper reference line. Then, without waiting for their crossover or a downturn, place an order to sell short below the low of the latest price bar. By the time Stochastic lines cross over, the market is often in a free fall. Once you are short, place a protective stop above the high of the trade day or the previous day, whichever is higher.
The shape of Stochastic’s top often indicates whether a decline is likely to be steep or sluggish. A narrow top of Stochastic shows that bulls are weak and a severe decline is likely. A Stochastic top that is high and wide shows that bulls are strong—it is safer to pass up that sell signal.
3. Do not buy when Stochastic is overbought, and don’t sell short when it is oversold. This rule filters out most bad trades.
When both Stochastic lines are headed in the same direction, they confirm the shortterm trend. When prices rise and both Stochastic lines rise, the uptrend is likely to continue. When prices slide and both Stochastic lines fall, the short-term downtrend is likely to continue.
More on Stochastic
You can use Stochastic in any timeframe, including weekly, daily, or intraday. Weekly Stochastic usually changes its direction one week prior to weekly MACD-Histogram. If weekly Stochastic turns, it warns you that MACD-Histogram is likely to turn the next week—time to tighten stops on existing positions or start taking profits.
Choosing the width of the Stochastic window is important. Shorter-term oscillators are more sensitive. Longer-term oscillators turn only at important tops and bottoms. If you use Stochastic as a stand-alone oscillator, a longer Stochastic is preferable. If you use Stochastic as part of a trading system, combined with trend-following indicators, then a shorter Stochastic is preferable.
Relative Strength Index
Relative Strength Index (RSI) is an oscillator developed by J. Welles Wilder, Jr. It measures any trading vehicle’s strength by monitoring changes in its closing prices. It’s a leading or a coincident indicator—never a laggard.
RSI fluctuates between 0 and 100. When it reaches a peak and turns down, it identifies a top. When it falls and then turns up, it identifies a bottom. The pattern of RSI peaks and valleys doesn’t change in response to the width of its time window. Trading signals become more visible with shorter RSI, such as 7 or 9 days.
Overbought and oversold RSI levels vary from market to market and even from year to year in the same market. There are no magical levels for all tops and bottoms. Oversold and overbought signals are like hot and cold readings on a window thermometer. The same temperature levels mean different things in summer or winter.
Horizontal reference lines must cut across the highest peaks and the lowest valleys of RSI. They are often drawn at 30% and 70%. Some traders use 40% and 80% levels in bull markets or 20% and 60% in bear markets. Use the 5 percent rule: draw each line at a level beyond which RSI has spent less than 5 percent of its time in the past 4 to 6 months. Adjust reference lines once every three months.
Each price represents the consensus of value of all market participants at the moment of transaction. The closing price reflects the most important consensus of the day because the settlement of traders’ accounts depends on it. When the market closes higher, bulls make money and bears lose. When the market closes lower, bears make money and bulls lose.
Traders pay more attention to closing prices than to any other prices of the day. In the futures markets, money is transferred from losers’ to winners’ accounts at the end of each trading day. RSI shows whether bulls or bears are stronger at closing time—the crucial money-counting time in the market.
RSI gives three types of trading signals. They are, in order of importance, divergences, chart patterns, and the level of RSI.
Bullish and Bearish Divergences
Divergences between RSI and prices tend to occur at important tops and bottoms. They show when the trend is weak and ready to reverse.
- Bullish divergences give buy signals. They occur when prices fall to a new low but RSI 87979797979makes a higher bottom than during its previous decline. Buy as soon as RSI turns up from its second bottom, and place a protective stop below the latest minor price low. Buy signals are especially strong if the first RSI bottom is below its lower reference line and the second bottom is above that line.
- Bearish divergences give sell signals. They occur when prices rally to a new peak but RSI makes a lower top than during its previous rally. Sell short as soon as RSI turns down from its second top, and place a protective stop above the latest minor high. Sell signals are especially strong if the first RSI top is above its upper reference line and the second top is below it.
RSI often breaks through support or resistance a few days ahead of prices, providing hints of likely trend changes. RSI trendlines are usually broken one or two days before price trend changes.
- When RSI breaks above its downtrend line, place an order to buy above the latest price peak to catch an upside breakout.
- When RSI breaks below its uptrend line, place an order to sell short below the latest price low to catch a downside breakout.
When RSI rises above its upper reference line, it shows that bulls are strong but the market is overbought and entering its sell zone. When RSI declines below its lower reference line, it shows that bears are strong but the market is oversold and entering its buy zone.
It pays to buy using overbought signals of daily RSI only when the weekly trend is up. It pays to sell short using sell signals of daily RSI only when the weekly trend is down.
- Buy when RSI declines below its lower reference line and then rallies above it.
- Sell short when RSI rises above its upper reference line and then crosses below it.
When we analyze markets, we deal with only a few numbers—the opening, high, low, and closing prices for each bar, plus volume, and also open interest for derivatives, such as futures and options. A typical beginner error is “shopping for indicators.” A trader may feel bullish about the stock market, but then he notices that the moving averages of the Dow and the S&P are still declining. Their bearish message doesn’t sit well with him; he starts scrolling through his software menu and finds several oscillators, such as Stochastic or RSI. Sure enough, they look oversold, which is normal in a downtrend. The eager beginner takes those oversold readings as a signal to buy. The downtrend continues, he loses money—and then complains that technical analysis didn’t work.
It is much better to use only a small number of indicators with a strict hierarchy for their analysis, including multiple timeframes.