In the last article, we looked at indicators on price. This week we try to answer one of the hardest questions in technical analysis. When is a market trending or ranging? Understanding what camp you are currently in will be crucial for your trading success. Many of the technical tools you will come across work better in the different periods of price action. We look in particular at one indicator; the Directional Moving Indicator (DMI), which tries to answer this question.
There are many ways to ascertain whether you think a market is trending or ranging. To start with you have to remember one very important statistic:
Markets trend approximately only one third of the time
With this key bit of information locked away in the background of your analysis, you will get to appreciate that tools such as moving averages (a trend following approach) are going to be pretty useless two thirds of the time and it is therefore crucially important to recognise if the market is trending or ranging!
How can you identify a trending or ranging market?
The most simple approach is by very quickly visually analysing your charts – often it is very obvious if a market is moving up, down or sideways. After building up experience, this approach can be very effective. But, being analysts we want to quantify our subjectivity somehow. A lot of this objective quantification will come down to a rules based filtering system of analysis.
Rules based filtering analysis:
You could use higher charting time frames to confirm whether the price is trending or ranging. If for example you are trading in the 30 minute charts, use the 4hr and 1 day charts to confirm the trend direction. If the trend / range is obvious in the higher time periods use that analysis in your trading window.
You can use other charting methods to determine the trend – for example, the Japanese charts: Kagi, Renko and 3 Line are all very helpful in determining if an asset is trending or ranging. Ichimoku as well – if the price is below the cloud price is bearish, above bullish and in the cloud neutral.
Moving Averages can also be used e.g. if the 20 moving average is above the 50 moving average is above the 200 moving average then this can determine a bullish trending environment. The angle of the trend in the average can also be important. Flat moving averages, or averages crossing each other in a tight group can indicate a ranging market.
The Parabolic SAR is a very useful indicator in a trending market but can catch you out when things go sideways.
Example: Parabolic SAR on the Nikkei 225 Index (Charts: TradingView) The system is denoted by the crosses above or below the price – above = bearish, below = bullish:
Directional Movement Indicator:
For me, there is only one indicator that stands out in the mainstream which very quickly gives you an impression as to whether a market is trending or ranging and that is the Directional Movement Indicator (DMI). This indicator was created in the ’70’s by one of the great technical analysts, J.Welles Wilder Jr. He set out to try to measure the directional movement in a mathematical equation of any commodity or stock and to scale it between upper and lower bands.
Example: Vodafone PLC (VOD:LN) (Charts: Stockopedia) incorporating the full DMI system:
Constructing the DMI:
Wilder used a default of 14-days in his calculations. 14 is not a number set in stone but is most commonly used. Today’s charting software allows you to change these inputs very easily – lengthening or shortening the inputs can slow down or speed up the signals the DMI will give.
Directional Movement is made up of three parts; Average Directional Index (ADX), +Directional Indicator (+DI), – Directional Indicator (-DI).
What do these three parts signify:
- + Direction Indicator (+DI) = upward trend movement
- – Direction Indicator (-DI) = downward trend movement
- Average Directional Movement Index (ADX) = if the market is trending or ranging.
Method to calculate the DMI:
Uses an Average True Range (ATR) approach so factors in the volatility of the instrument.
1. Calculate : True Range (TR), +DM and -DM) for each period and smooth values.
2. 14-day smoothed +DM / 14-day smoothed TR = +DI14 * 100. (+DI14 = green line)
3. 14-day smoothed -DM / 14-day smoothed TR= -DI14 * 100. (-DI14 = red line)
Then need to calculate the ADX:
1. DX = absolute value of +DI14 minus – DI14 / sum of +DI14 and – DI14 *100.
2. ADX = 14-day average of DX, then smoothed.
Using the DMI:
The indicator is very simplistic in its application. The rules I am going to lay out here to get you started, are based on Wilders initial model. As the decades have rolled on, other technicians have adapted and tweaked the set up.
- When the +DI crosses above the -DI a long position is taken
- When the -DI crosses above the +DI a short position is taken
- ADX >25 = trending
- ADX 20 or less = ranging
- On the day that +DI and -DI cross, the reverse point is the extreme price made that day.
- If you are long: the reverse point is the low made on day of crossing
- If you are short: the reverse point is the high made on day of crossing
- When the ADX is > the -DI or +DI indicates a turning point
- When ADX< both DI lines stop trading – especially a trend following system
- Use the crosses as a trend indicator: If +DI > -DI = long, if -DI > +DI = short
Example: Nikkei 225 daily chart (Charts: TradingView):
Which indicators work better in trending or ranging markets?
Once you have finalised the tool or method you are going to use to determine whether a market is trending or ranging you need to be aware that certain technical tools work better in the different situations. From my own experience, I find moving averages, Parabolic SAR, MACD work better in a trending environment and stochastics work better in a ranging environment.
Further reading and learning:
If you are interested in learning more about trending or ranging indicators, then the following reading may help:
- New Concepts in Technical trading Systems, J.Welles Wilder Jr, Hunter Publishing Company, 1978.
- Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
- Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.
Factoring in to your trading and investing whether a market is trending or ranging will be imperative to your success. There is no point coming up with a great strategy that only works in a trending market and loses you your shirt if you continue to trade it through a ranging market. Why also enter a long or short position if the market is dead and flat? As we have seen, the DMI can quantify and simplify your analysis further. Hopefully this article has given you an insight as to why trying to answer the question of ‘is a market trending or ranging’ is important.
Next time: Technical Analysis (Part 13): Direct Price Analysis (DPA) – Fibonacci