We have assumed that the market was about to trend in both the 65sma-3cc and the CB-PB systems, although we did not actually verify that the market was trending because it is difficult to measure trendiness consistently. As was shown in the discussion in chapter 3 on the range action verification index, market momentum is often a good measure of trendiness. Unfortunately, a certain amount of smoothing is essential to minimize noise in the indicator, and this smoothing usually causes undesirable lags in indicator response.
Figure 4.23 shows the March 1993 U.S. T-bond contract trending upward nicely from December 1992 through March 1993. The indicator under the daily bars is the 18-day average directional index. ADX measures the amount of activity outside the previous bar over a given period; a strong trend usually leads to a rising ADX line. An ADX reading above 20 is considered to indicate a trend, but the ADX is a lagging indicator, and there is little significance to any particular indicator value.
ADX is closely related to double-smoothed absolute momentum, and hence will often have quirky lags. The ADX will often seem to be late in signaling a trend, and choppy markets will not follow through in the original direction that caused the ADX to rise. In fact, the market can reverse strongly, and the ADX will keep on rising.
During a strong trend, as markets make big daily moves in the direction of the trend, the daily ADX momentum can “pop” over 1.0 point, an ADX “burst.” Figure 4.24 shows the March 1993 U.S. bond contract with the histogram of the ADX burst superimposed on the 18-day ADX line. As the trend accelerates, the daily ADX changes are more than 1, and you can see relatively large bars associated with this ADX burst activity. Now you can build a trading system using this idea as shown in Figure 4.25, where the entries are circled.
Obviously, the ADX burst indicates accelerating momentum. So, here the design philosophy has changed to begin with a check that in-creases the odds of success of a trend-following strategy. Notice that the ADX burst is itself triggering the trade, and that the ADX is not acting as a filter. For reference, you can look up a similar system in Lucas and Le Beau (see bibliography for reference). Our goal is to take the trade in the direction of the short-term trend. If the 3-day SMA is greater than the 12-day SMA, then the trend is up, and vice versa. Table 4.12 shows the results using a simple 20-day exit strategy and allowing $100 for slippage and commissions, over all available data from Janury 1, 1975, through July 10, 1995.
The rather large profit factor suggests that the entries are effective in identifying profitable trades, so that an ADX burst is a good entry into strong trends. The profit factor is overestimated here to some degree because we are using continuous contract data. The results can be improved with multiple contracts, and you can try a variety of other exit strategies.
If you compare the number of trades here to that for the 65sma-3cc system, you will find that you have fewer entries, suggesting that the ADX burst is working as both a trade filter and a trigger. For example, this system was in the market about 35 to 45 percent of the time, indi-cating it has a rather large “neutral zone.” A trading system with a neu-tral zone is out of the market unless it rises above stiff entry barriers. The 65sma-3cc system is always in the market, and is a reversal-type system, whereas the ADX burst system steps aside 55 to 65 percent of the time.
We used a wide initial stop of $5,000 in these calculations to isolate the performance of the system. Table 4.13 includes performance data on selected markets with an initial stop of $1,500. The performance with the two different initial stops was generally similar.
One of the quirks of the ADX burst system is that it will often get in late, near the tops or bottoms of short but swift moves (see Figure 4.26). Such moves fire its entry signals, but the capricious market fails to follow through with a trend in the advertised direction. Hence, you should always trade a system such as this one with a preplaced stop loss order.
Figure 4.26 The June 1990 U.S. bond contract sells off beyond a trading range to make a new low with good momentum. The system kicks in with a short. The bond market soon reverses, to get back into the prior consolidation region.
In summary, the ADX burst system provides entries into strong trends. It tests well across many markets and over long time periods. The system has a large neutral zone, so it is in the market only 3 5 to 45 percent of the time. It differs from the 65sma-3cc system, which is always in the market, and does not have a trend filter. You can use it to enter trades or increase the position in those markets. You can derive other variations using different values of the ADX burst, the look-back period for the burst calculations, and other exit strategies.