Today, we will discuss a few popular indicators, their purposes, their strengths and their weaknesses. We will also look at some guidelines on how to set your lengths and time periods when working with these indicators. ADX (Average Directional Movement Index) Is a technical tool that measures the strength of a current trend. The higher ADX is, the more powerful the trend. ADX can be used to find powerful trends that traders suspect will continue. It can also be useful to look at the 2 main components of ADX, the DM+ line and the DM- line. If find it extremely useful to buy on bullish crossovers and to sell short on negative crossovers. ADX is also an excellent confirmation tool when you are using a trend based (as opposed to reversal-based system). I have not tested thouroughly enough yet, but it could be useful to use ADX to find stocks whose trends have lost their power. For example, I've noticed that many trends lose their power at the 40 level in ADX. At this point, most trends can continue no longer. That means that an ADX reversal at the 40 level can also be an excellent exit signal for long positions and an excellent indicator for entering short positions. We may be testing this further and discussing the results later.

Beware of the weakness of ADX. ADX tends to look bullish too late during medium and small trends. ADX is rarely able to recognize market bottoms and exact turning points except when looking at DMI crossovers.

Stochastics

Stochastics is an extremely effective trading indicator. There are several ways to trade this indicator. It can be used both to find reversals and also to find powerful trends. For example, I find it extremely effective to use stochastics to confirm that a powerful trend is in place. Use the 80 level and 14 days as your settings. Another extremely effective way to trade stochastics is to watch for a K-line crossover of the D line while below the oversold level. When you see an upward crossover (K line crosses above the D line) while under the oversold level, this is a fantastic tool for finding stocks that are emerging bullishly from oversold. This technique is actually one of the best performing techniques I have ever found in back-testing. Make sure that if you are using software to trigger this signal, that the language only gives you a signal when the crossover occurs and stays completely under the oversold line on the same day. If it crosses over oversold on the same bar, it decreases the effectiveness of the signal. It seems as though stochastics is telling us that this stock is finally emerging from the doldrums, but if it moves too much, it's often a fakeout.

Percent R

We have tested %R and found that it works extremely well as an exit signal. It's highly effective to use a percent R length from 10-14 and an overbought level of over 90. If you see Percent R cross above the OVERBOUGHT level, watch it, because when it crosses back below, this is an excellent sell signal. The great thing about percent R is that it looks at the highest high and lowest low in a predetermined date range and identifies those points as points of short-term resistance and support. This is just one way to use % R. One major weakness of Percent R and stochastics is that they both fail when stocks continue trending powerfully in the same direction. These 2 oscillators are good at finding short-term reversals, oversold, and overbought conditions. However, there are times when stochastics and Percent R indicate that oversold conditions exist and the stock continues to drop. Beware of this risk and this tendency. The reason we use these 2 indicators, is that although they fail sometimes, they work more often than they don't. That wraps up our discussion of 3 popular indicators and how to profit from them. If you have time to research, keep testing your ideas using various software.

Price Headley is the founder and chief analyst of BigTrends.com.