Adding the ADX to Your Trading Toolkit

The following is a reprint of the market commentary from the November 2017 edition of The Option Advisor, published on October 27. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month --  visit our online store.

Long-time followers of our options recommendations will likely be familiar with the acronym F.A.R., which describes the ideal trajectory for the asset underlying a purchased option -- namely, the stock's movement should be Fast, Aggressive, and in the Right direction. Focusing your option-buying efforts on equities that make big moves over short time frames helps to minimize the impact of time decay, while simultaneously maximizing your leverage.

But how do we find stocks primed for this type of powerful movement? One useful technical indicator for these purposes is the Average Directional Index (ADX), which aims to measure both the strength and direction of a stock's price trend -- two key components that successful option buyers need to get right.

The ADX itself (as developed by Welles Wilder) is non-directional, and simply reflects the strength of the trend. In order to determine the ADX, the direction of the trend is first established by way of the positive directional indicator, notated as +DI, and the negative directional indicator, represented as -DI.

These two components, in the simplest of terms, are based on a moving average of the underlying asset's average true range, most often over a 14-day period (similar to Welles' widely used Relative Strength Index). When the +DI crosses above the -DI, the trend is said to be bullish. And when the -DI is above the +DI, a bearish trend can be confirmed (note that this indicator is lagging and not leading, and as such is therefore best used to confirm existing trends, rather than to predict future moves).

Then, based upon the relationship between the pair of directional indicators described above, the ADX is given a value between 0 and 100. Readings below 20 are reflective of fairly weak price trends, and readings above 25 are generally considered to correspond with strong price trends.

As of this writing, Ford Motor (F) has a +DI of 26.97, -DI of 19.46, and ADX of 29.69 -- checking all the boxes for a strong bullish trend. General Electric (GE), meanwhile, sports a +DI of 12.33, -DI of 30.42, and ADX of 24.60, pointing to a fairly robust bearish trend. As for Apple (AAPL), the combination of a +DI of 21.97,-DI of 25.39, and ADX of 12.61 is indicative of a weaker bearish trend.

Given its status as a lagging indicator, it's important to note that ADX should not be viewed as a predictive signal, but instead as a confirmation signal. That is, an ADX that aligns with the other facets of your technical analysis (based on moving averages, round-number percentages, percentage returns from key highs and lows, and etc.) should be considered as "sealing the deal" on your price forecast, as opposed to providing the sole basis for your price forecast.

In keeping with the F.A.R. principle outlined above, options buyers will want to hone in on stocks with an ADX of 25 or higher and rising (suggestive of a strong trend that's getting even stronger). Consistent with our contrarian philosophy, we've found the greatest success when strongly trending stocks are surrounded by analyst and investor sentiment that directly conflicts with the confirmed price trend -- such as high short interest and a preponderance of "hold" or "sell" ratings on uptrending stocks, or feverish call buying and an overload of "buy" ratings on downtrending stocks.

We recommend using the ADX in concert with your usual array of technical analysis tools, along with a careful review of the sentiment backdrop, to help you pinpoint stocks set to make the kind of aggressive directional moves that makes option buying so rewarding.

And while we feel we've sufficiently driven home the idea that ADX is neither a standalone buy/sell signal nor a predictive tool, it's worth pointing out that there are no fewer than four S&P 500 Index (SPX) components where the ADX has accurately predicted the magnitude (if not the direction) of the stock's one-month returns. The chart below displays data since 2010, and one-month returns for each stock following strong bull, weak bull, weak bear, and strong bear ADX signals are neatly aligned in descending order from strongest to weakest (going from left to right, with a green "1" denoting the highest average return and a red "4" denoting the lowest average return for each equity).

That said, note that even the "strong bear" signals for those top four stocks yielded positive average returns after a month (albeit smaller positive returns than those signals in the preceding columns). What's more, witness the general disarray in one-month post-signal returns for the remaining 10 tickers in this table (sorted by market cap).

In conclusion, those looking to augment their technical analysis approach with new tools would do well to include ADX in their consideration of potential option-buying ideas. Like most other indicators, it's not a magic bullet for generating lucrative option-trading ideas -- but it's certainly a metric well-calibrated to help option buyers drill down on stocks that are positioned to go F.A.R. (with apologies for the pun).