Our recent volatile but sideways market trend can favor sellers of options and those who bet on a range bound market. It's vital for options traders to correctly figure if a stock or index is/will be trending OR going into a sideways/non-trending period. To project what's going to happen in terms of a strong, weakening or sideways trend in stocks or stock indexes quickly enough to take advantage of either scenario is one tough task. A trader wrote me recently asking if there were any technical indicators that would help define when the market was in a trending or 'non-trending' period.

In the commodity futures markets the question often came up as to whether it was appropriate to use trend following methods, or not. Welles Wilder ("New Concepts in Technical Trading Systems") came up with a couple of indicators that helped provide a statistical determination or guide for whether a market was going into a trending period or not.

The basic method I use for forecasting a sideways range bound period is by trendline analysis, which includes periods when two parallel lines connect various highs and lows and visually 'define' a sideways trading range. (Wave pattern forecasting can also be a help at times.) Since how one trader will construct trendlines and interpret them versus someone else can vary significantly and be subjective, I will describe and explore two common mathematical formulas for determining TREND direction or the lack thereof.

Both indicators are part of Wilder's Directional Movement Index or DMI. Wilder developed his indicators using the futures markets, but they're applicable to other markets; e.g., stocks and stock indexes. An additional indicator called the Average Directional Movement Index (ADX) is often used as part of the DMI study and sometimes used alone. I put them on separate charts, not only because they show different aspects of trend, but for the sake of not 'cluttering up' a single chart.

My first chart is of the daily S&P 500 Index (SPX) through today (11/30/10) with the ADX indicator and the Directional Movement Index system seen below it. Obviously, SPX has been in relatively narrow trading range between 1200 and 1180 on a closing basis. Another description for a trading range market is a NON-trending period.

The ADX and DMI indicators seen above help determine when SPX is in a trending mode. Both indicators 'length' settings are set to the Wilder default of 14. As this then utilizes 14 days of Closes, the indicators will lag and change somewhat slowly over time, as is appropriate for indicators that attempt to measure the intermediate-term daily trend.

The ADX line is a way of 'rating' directional movement. The higher the value, the stronger the trend EITHER up or down. A value below 20 suggests a non-trending period or that of a sideways trading range. This indicator on the SPX chart dipped below 20 on the 11/18 close. This suggests a period when selling premium may be advantageous such as in strategies depending on stock or index prices not ending up outside a certain range.

An earlier prolonged period when ADX was also below 20 is highlighted in yellow. During this period there were short-term trading swings in both directions but not enough up or down momentum to 'define' an intermediate-term trend that was strongly up OR down.

The DMI, Directional Movement Index, also seen in the SPX chart above, consists of TWO lines: a plus (+) Directional Index (DI) and minus (-) Directional Index (DI). The +DI line measures positive upward movement and the -DI line measures downward movement. A buy 'signal' is given when the +DI line crosses above the -DI line. Conversely, a sell 'signal' is generated when the +DI line crosses below the -DI line. As long as +DI line is above the -DI line this indicator is suggesting to be in calls and other bullish strategies. As long as the -DI is below the +DI line, the indicator is suggesting to be in puts and other bearish strategies. Such a sell signal was generated on the 11/16 SPX Close. A 'FILTER' so to speak for the +DI and -DI crossover buy/sell 'signals' is to NOT take a new DIRECTIONAL trade when the ADX line dips below 20, especially well under (e.g., -15). Sometimes it may be warranted to stay in a profitable trade that was put on before ADX dipped to below 20 (non-trending).

Lastly, I would point out the tendency for 'whipsaw' buy/sell signals (one following the other and usually short-lived) when the ADX model is showing a non-trending period below 20. This is seen with the DMI indicator during the earlier non-trending period highlighted above in the yellow box.

Whipsaw type action is seen below in the Nasdaq 100 (NDX) daily chart in terms of DMI directional buy/sell signals after ADX dipped below a 'non-trending' 20 in the past couple of weeks. There have been 4 DMI buy and sell crossover type signals in fairly rapid succession in this relatively short period.

To sample the ADX trending/non-trending indicator, coupled with the DMI model on some stocks, my next two charts are of interest.

With IBM, a break of its most recent up trendline has been followed by enough of a sideways move to cause the ADX indicator to fall below 20 and confirm a loss of (upside) trend momentum. The ADX line actually peaked after the stock fell under its steeper Sept-Oct up trendline. The second (lower) trendline break has now led to enough of a sideways move to pull the ADX line into non-trending territory.

Predictably, as the trend has weakened, the DMI crossovers are getting less reliable in terms of suggesting a prolonged trend. Working with trendlines, coupled with these technical trend indicators, can be a useful package. The indicators provide a type of 'objective' confirmation to what is seen visually with price action relative to IBM trendlines.

PROFITS GO BETTER WITH COKE?

Coca Cola stock (KO) has been in a strong uptrend but the two trendline breaks (one short-lived) are having the effect of pulling ADX lower. The Directional Movement Index (DMI) model is still on a buy 'signal' and there hasn't been much downside yet and there may not be much more. Stay tuned on that, but we can see from ADX that this formula for trend is losing steam. This may be the time for the call holders to take profits and go have a break with a pleasant beverage.


GOOD TRADING SUCCESS!