figure 3.3 a trending stock with a nontrending indicator. the indicator gives several bad signals against the direction of the trend.

Nike Inc (Daily)

Source: AIQs TradingExpert. Used by permission.

figure 3.4 a trending stock with a trending indicator. the indicator is bullish for the majority of the advance.

Source: AIQs TradingExpert. Used by permission.

table 3.3 dmi signals for nike inc.

indicator kept us in the security as the security moved higher. The actual signals registered are listed in Table 3.3.

The DMI worked well for this trending security, but loses its effectiveness for nontrending securities. Figure 3.5 is a chart of Louisiana Pacific (LPX) along with its DMI. Looking at the arrows, we see many signals were registered but the majority of them turned out to be whipsaws. The actual signals registered in this example are listed in Table 3.4. The majority of the signals were unprofitable.

Figure 3.5 A trading stock with a trending indicator. The indicator frequently gives whipsaw signals.

Source: AIQs TradingExpert. Used by permission.

TABLE 3.4 DMI SIGNALS FOR LOUISIANA PACIFIC

Trending Security, Nontrending Indicator

When an indicator that works well in a nontrending market is applied to a trending security, it tends to give bad signals against the trend. Does this mean the indicator should be ignored? Not so fast. By making adjustments to an indicators interpretation, we can effectively apply a nontrending indicator to a trending security.

The first adjustment is to simply ignore all signals against the trend of the security. These indicators give frequent sell signals during a strong advance. These signals should be ignored. This does not mean you should not have an exit system in place. It means that the exit system should not involve the use of nontrending indicators.

The second adjustment is to change the requirements for buy or sell signals so that the indicator gives signals in the direction of the overall trend. Using defaulted values (values recommended by the developer), a stochastic or Relative Strength Index (RSI) rarely gives a buy signal for a strongly advancing security. As a result, the oversold levels should be adjusted upward so the indicator will give buy signals. Instead of the normal default value of 20 for the stochastic, the oversold level should be raised to 50 for a strongly advancing security. Then a stochastic buy is registered anytime the indicator falls below and then rises above a value of 50.

An example is found in Figure 3.6, which displays the Dow Jones Industrial Average for 1995s strongly advancing market. We know the market is in a strong uptrend because its 28-day moving average is not broken. Using the default buy and sell values for the stochastic, the indicator failed to give a single buy signal in 1995 but gave sell signals almost every week of the year. Not very effective.

By making our adjustments, we identify the strong trend and therefore ignore the sell signals from all nontrending indicators. By raising the oversold level of the stochastic, buy signals are registered when the indicator falls below and rises above 50,