Follow-up: ADX analysis, $DDX, $INDU, and Gold (GG).

This post is a follow-up to my last post on 7/29/08 where I described how to use the ADX to find active sectors, and how to zero in on various stocks in the sector which have potential both on the long side (betting the stock will go up) and on the short side (betting they will go down).

Interestingly enough, on Monday, the volatility (activity) as tracked through the ADX on all three sectors dropped which made the sectors not worth investing in. If I were in a position based on my Sunday research, I would probably look to close the position, hopefully for a profit.

Before the trading session on Monday, I looked at the stocks within the various sectors. The Dow ($INDU) was just too big to focus into a few stocks so I passed on looking for shorts, especially because they are so difficult to time. As for the AMEX Disk Drive Index ($DDX), I looked at the few stocks in that group, but I noticed that none of them were moving more than a few cents each day -- that is not the kind of movement I need to make a profitable trade. In short, in order for a trade to be worth one's time, I learned that one should choose stocks that historically move at least $1.50 or more in one trading day. Because these stocks were moving less than $0.70 each, it wasn't worth my time and so I passed.

This brings me to the PHLX Gold and Silver Sector Index ($XAU). While the ADX dropped a bit, I saw the index move up closer to a breakout point above the range it has been trading in. I purchased a leading gold stock (GG), and on Monday, it broke out even though the ADX was no longer supporting high volatility moves [note that the breakout in the $XAU ended up being a FAKEOUT. In Japanese stock language, the name for what the $XAU did was called "man go to roof and fall off cliff." I'm actually not kidding! So, needless to say, I was cautious to make sure my stock (which follows the index) didn't also fakeout, but the stock stayed above the trading range which was a good sign.]

It's interesting to note the similarities between the movement in the $XAU and in the GG stock. I've pasted both pictures below.





If you'll notice, I had my initial stop at $46.30, right before the stock broke out. I'm not exactly sure why I chose that point, but I believe that I wanted to give the stock a chance to correct a bit before taking off again, and in the past I had a tendency to set the stops too close to the stock which means that I would get stopped out, and then as soon as my stop was taken out by the stock, it would turn around and go in the direction I initially thought it would. This was and still is a tough lesson to figure out how to prevent this from happening, however the risk is that the stock will tomorrow fall back below my stop and I will have lost the tiny profit I made today.

In my honest opinion, a 2-day base is no base at all, so any stop at this point is arbitrary. With the volatility of the stock dropping like a rock as it did, tonight, I'll probably set the stop right below the gap up this past morning and see what the stock does from there. My guess is that the stop will be taken out around 10am tomorrow morning giving me a small loss. Let's see what happens.

I also mentioned EMC and SNDK. Because of the drop in volatility, I decided not to trade either stock. As you can see from the stock below, EMC dipped below the 2-day trading range (which is not a reliable base which should be in existence for weeks, not for days) and then slivered back up to the bottom of the trading range. Had I invested (and if I followed my own advice and shorted this stock, my trigger of $14.45 would have been set off, I would have entered this trade this morning, and I would have ended the day in a small loss.) That being said, I stayed away from this stock because of the volatility, even though it might end up going down as I suggested it might. The chart is below.



Lastly, I mentioned SNDK. Had I shorted this stock as I suggested, my buy signal would have triggered at $18.85 and the stock would have been in a profit. However, this trade never happened because the ADX (volatility) fell Monday morning to a point which I didn't feel that the stock would have been worth the trade.

ADX sector scan -- Dow Jones & Gold.

As far as I understand, the ADX indicator shows market volatility (higher ADX = more volatile stock or sector; lower ADX = less volatile stock or sector). I learned some time ago that one should use the ADX to forecast stock breakouts or breakdowns, but it can also be used to indicate possibly healthy price movement in a stock (up or down.) It should also be used when scanning the sectors to find stocks. Using the 10 day, 15 minute chart is a good time frame to look at when doing scans. ADX lines that are above 40 and are above both the +/- DG lines are what we are looking for.

While scanning the sectors, most sectors seem to be uninteresting or spent, meaning that if anything was to happen, it already happened. However, three sectors show some momentum under the surface -- Gold, the Dow, and the AMEX Disk Drive Index.



First of all the Dow looks terrible. It is below pretty much every major moving average, and it has some major work to do before I would even consider buying stocks in this index. Prudently, if it broke above $11,950 (or even higher to give it some cushion for a fake-out,) I'd give it a second look. On the downside, a break below $11,250 would give me some reason to look at the stocks for further downside testing.

I have learned that shorting a stock is very difficult because it is not easy to get the timing right. Stan Weinstein teaches to just flip his risk-management teachings for bull markets to understand how to sell stocks short (or to buy puts), however William O'Neill and many others say it is much more complicated than that, and your chances of losing money on a short are much higher than when the stock is going up for the sole reason that the timing is just difficult to understand and to master. All this being said, NEVER SHORT STOCKS WITHOUT A STRICT DISCIPLINE AS TO WHEN YOU WILL SHORT AND WHEN YOU WILL COVER because if a short bounces up and you haven't already put in the 60-day GTC STOP order to the upside, you can wind up losing a lot of money fast.



As for gold stocks, it appears to me that a break above $197 on high volume would signal that it's time to start buying gold and silver. The index is above its averages, and the ADX is at 51, which suggests to me that people are ready to start buying in this sector. From a quick scan, I believe the leading stocks are GG, ABX, and PAAS when it comes to buying gold.



As for the AMEX Disk Drive Index ($DDX), this one was a tough one to understand. It appears to me that there is high volatility, and that a break below $109 might be just enough to push it over the edge (and possibly off a cliff.)

I did some analysis on the underlying stocks, and some of them have very low volatility, so I passed on considering them. Other stocks were choppy and so I didn't trust the movement. Others were too low a price, or had their RSI (relative strength) too high which means that I don't want to be shorting a strong stock. My logic is that just as one should buy the strongest of the strongest, similarly, one should sell short the weakest of the weakest, albeit the weakest with the highest volatility.

Of the remaining stocks, I found the two candidates for a short sale were EMC and SNDK. While they both are stocks under $20, we are looking for a short sale and not a purchase, so in theory the stock can go as low as zero.



Regarding EMC, I would consider a short at $14.45 with a stop (cover) at $15.25. The reason for this is that even though it is trading in a downtrend channel, there is still a base (a trading range) where it is trading.



As per SNDK, I am not so excited about a trade with this stock, I would consider a short at $18.85 with a stop (cover) at $20.60. There is a more focused trading range, but you always want to give the stocks some room to bounce and wiggle.

All in all, I wouldn't be comfortable making any sort of trade unless the ADX rose above 40. Further, I would hesitate with SNDK because average traded shares (volume) is ~297K, slightly below my threshold discipline of 300K shares.

On final review, however, I noticed that the price movement of the stocks in this sector have not been more than 70 cents in one day. I learned that a proper trade should be a healthy stock moving either up or down on high volume, but with a dollar amount of at least $1.50 to $2.00. Anything beyond that is not worth the trade or the risk. Thus, I suppose the disk drive sector so far is not yet the place investing dollars should enter.