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Using an indicator by itself can reveal a portion of the entire picture. Combining it with another can reveal more.

Traders use technical indicators to recognize market changes. They look to indicators for signs of price direction, momentum shifts, and market volatility. Among the most sought-after indicators are those that identify price trends. Traditionally, moving averages serve that purpose, but they suffer from whipsaw action during price consolidations. However, there is another approach. This article shows how to combine two popular indicators to help traders detect not only trend direction but also trend strength.

The indicators involved are the average directional index (ADX) and the moving average convergence/divergence (MACD). The ADX functions as a trend detector, rising as price strengthens into an identifiable trend and falling when price moves sideways or loses its trending power. ADX values in the 20 to 30 range indicate mild to moderate trending behavior, while values above 30 usually signify a strong trend.

Unfortunately, the ADX does not reveal the trend direction. The MACD, on the other hand, indicates price momentum and can also be used to identify price direction as it rises above its trigger line or falls below its zero line.

When both indicators are plotted on the same chart, trend strength and trend direction become clear. The chart of AOL Time Warner (AOL) in Figure 1 illustrates how the two indicators complement each other. The ADX in the upper panel rose from April through May 2001, indicating a trending market. The MACD rose above its dotted trigger line and its zero line, showing that price direction was up.

During July and August the ADX rose once again, but the MACD was then below its trigger line and its zero line, showing that a downtrend was in progress.

THE CONFIRMING PATTERN

Most traders prefer the long side of the market and look for an uptrending market. The confirming pattern identifies exactly that condition. When the ADX and MACD move up in unison, they confirm rising price direction; the Bristol-Myers Squibb Co. (BMY) chart in Figure 2 offers a good example of a confirming pattern. The ADX and MACD rose as price moved up strongly in September to December 2000.

When price changed direction in January 2001, both the ADX and MACD followed suit. The falling ADX was not indicating that a downtrend had begun; merely that it no longer could find a trend. In this example, the MACD showed that price was retracing its prior upward march. But sometimes when both indicators fall, price forms a sideways trading range, rather than the more pronounced downward move seen in this chart.

THE DIVERGING PATTERN

The indicator combination shines when a price downtrend is in progress and they form a divergence. The ADX rises as it identifies the trend, while the MACD falls below its trigger line and often below its zero line. The two indicators no longer move in tandem; instead, they diverge and form almost a mirror image of each other. During the severe 2000–01 decline in Cisco Systems (CSCO), the ADX-MACD combination formed several easily identifiable diverging patterns as one rose and the other fell (Figure 3). They reflected the falling prices in September–October and December 2000 time periods, as well as the continuing decline in February–March 2001.

The diverging indicator pattern should warn those who want to go bullish to stay out of a stock. However, for those who wish to sell stocks short or purchase put options, the diverging pattern provides a visual gold mine. But expect a price shift when the indicators stop moving apart and begin to move toward each other (as they did in April and May).