Combining ADX with RS to Find Intermediate-Term Trades

As an intermediate-term trader, I don't rely on mechanical indicators to time my trades. For long trades, I scan for high relative strength stocks. For short trades, I scan for low relative strength stocks. Then I manually eyeball the charts for valid patterns and pick my entries based on breakouts.

However, while I don't use indicators to time trades, I've found them useful in refining my database scans for basing stocks. One useful technique is combining low Average Directional Movement Index (ADX) readings with high RS scores for long trades or with low RS scores for shorts.

I got this idea from Larry Connors, who suggested a high RS/low ADX combo could smoke out stocks that have displayed powerful performance relative to general market, then have moved into narrow trading ranges.

Not all the stocks generated by the screen will pass muster when I inspect their charts. If you use this screening approach, either on TradingMarkets' StockScanner or some other proprietary software or database, be prepared to sift through plenty of chaff in order to get to the wheat. However, I've always found this to be the case. Intermediate-term momentum trading is discretionary trading. No scan will relieve of you of the necessity doing plenty of homework to zero in on the best possible trades.

Relative strength measures of a stock's performance vs. a universe of stocks or an index such as the S&P 500. In the case of database scans, most RS searches use a percentile system. A stock with a six-month RS rating of 85, for instance, outperformed 85% of all stocks in its database set or universe over the past six months. A stock with a 12-month RS of 15 has lagged 85% of its peers.

ADX measures the strength of a trend. So a low ADX score could help locate stocks which are moving sideways. It tends to be a lagging indicator, so you'll get a lot of stocks that have broken higher or lower despite their low ADX readings. Nevertheless, it can lead you to stocks which are putting in consolidations.

By combining extreme RS scores with low ADX scores, I am seeking stocks that have forged strong intermediate-term uptrends or downtrends, then are pausing. Some of these will be putting in bases.

I encourage you to experiment with your own settings. Here are three long trades that came up on Nov. 29, 2000, shortly before their breakouts, using a 12-month RS filer of greater than or equal to 80, a three-month RS greater than 80 and an ADX of less than or equal to 25. The stock should be above its 200- and 50-day moving averages. You also can add other filters to suit your tastes in terms of average daily volume and minimum price. I suggest excluding stocks with prices in the single digits and daily average trade below 300,000 shares.

Dime Bancorp (DME | Quote | Chart | News | PowerRating): 12-month RS 84, three-month RS 94, ADX 13:

Doral Financial (DORL | Quote | Chart | News | PowerRating), 12-month RS 81, three-month RS 88, ADX 21:

Consol Energy (CNX | Quote | Chart | News | PowerRating): 12-month RS 83, three-month RS 89, ADX 15:

As you can see from Consol Energy, this scan is not a timing tool, it's a base-locating tool. The idea is to locate bases as they are forming so that you can monitor the stock going forward as you watch for the breakout.