Profiting From TradingMarkets: How To Use The Stock Scanner–Part 2

Editor’s Note:

 

Scanning for
Profits, Part II: Using ADX

By Dave Landry

Shorting, The Rules
Are Reversed

If you buy XYZ 100 and later sell it
for 102, you make a profit, less commissions, of 2 points. In shorting, the
rules are reversed, you sell the stock first (known as selling short), then,
hopefully, buy it back (known as “covering”) cheaper in the future. So if you
sold XYZ short at 102 and it later dropped to 100 (vs. rising in our first
example) you would make a profit of 2 points (102-100 = 2). For a refresher on
shorting, see

Shorting Stocks: The Art of Playing Both Sides of The Market.

RS vs. ADX

As a momentum player on the short
side, you should look for stocks that are in established downtrends–the
complete opposite of a momentum player on the long side. Last time, we used
relative strength (RS) to find candidates on the long (buy) side. However,
because relative strength (RS) is a measure of strength not weakness,
stocks with low RS aren’t necessarily in downtrends. Often they are simply being
outperformed by other stronger stocks. So a stock that has been going sideways
for quite some time may have a low RS reading. This is especially true in
strong market conditions. Therefore, in order to find stocks in downtrends, it’s
usually better to use an indicator such as Average Directional Index (ADX) which
measures trend.

ADX Refresher

Before we get into the actual scan, a
quick rehash of ADX is in order. ADX is based on directional movement (DM)
calculations. If more of today’s range is above yesterday’s range then that
range (above yesterday’s high) is measured as positive directional movement
(+DM). Conversely, if more of today’s range is below yesterday’s range, then
this range (below yesterday’s low) becomes negative directional movement (-DM).
This is illustrated in Figure 1 below.

 

Figure 1

 

The ADX is calculated by taking the
smoothed difference (also known as DMI) of the +DM and the -DM. There are
special situations on how the DM is calculated but understanding the above
should be enough for the purposes of this article. For those interested in the
details, refer to the article:

Capturing Trends With The ADX.

ADX measures trend, not direction. The
higher the ADX, the higher the trend. To determine direction, the positive
directional index (+DMI) vs. the negative directional index (-DMI) is analyzed.
If the +DMI is greater than the -DMI then the stock is considered to be in a
uptrend. Conversely, if the -DMI is greater than the +DMI, then the stock is
considered to be in a downtrend. Because we are focusing on potential shorting
candidates for this article, let’s look at an example of a stock in a downtrend
as measured by ADX and -DMI > +DMI.

Figure 2

 

Referring to Figure 2 above, American Express (AXP),
notice that on the date of the scan (03/03/2000), AXP had an ADX of 35.36.
Further, the -DMI is greater than the +DMI. All this suggests that the stock is
in an established downtrend. A simple “eyeballing” of the stock confirms this as
the stock has recently lost nearly 30% of its value.

 

How High is “High”?

We stated that stocks with a high ADX
are said to be in trends but how high is high? Most textbooks claim that a stock
is said to be trending if the ADX is greater than 30. However, it’s really a
function of the market. If the overall market is choppy, then there will be
fewer stocks with ADX readings over 30. Therefore, in order to find stocks that
are trending (relative to the market), you would have to reduce your minimum ADX
readings to, say, 25. On the other hand, if the overall market is in a strong
trend, then you may have to increase the ADX settings in order to help reduce
the number of stocks.

The Scan

In order to find candidates that were
trending lower, I used an ADX of 35 or higher and required the -DMI to be
greater than the +DMI (which equates to “down” in the scanner). As previously
stated, there are no “exacts” when deciding how high of ADX should be used.
Thirty five was used because lower minimums were producing too many stocks as
the broader market was in a downtrend at the time the scan was run. Like last
time, we used a minimum average volume of 500,000 (which equates to 5,000 in the
StockScanner). This was used in order to give us a representative sample of
stocks in downtrends (vs. measuring thinner volume issues, see

Scanning For Profits Part 1 for more details on using volume in the
scanner). Also, when shorting, you want to focus on somewhat higher volume
stocks in order to help avoid being caught in a “short squeeze” which tends to
happen more offer in thinner issues (refer to the

article on shorting for details). For this scan, we used a minimum price of
45. This was used for several reasons, 1) it helps narrow the focus 2) like the
volume requirements, provides more meaningful representation of stocks vs.
lower-priced stocks 3) when shorting stocks, your profits are limited to the
maximum amount the stock can drop, therefore, higher priced stocks tend to offer
more opportunity, especially for the short-term trader (again, see

Scanning For Profits Part 1 for a discussion on price).

Figure 3 below shows what the above
scan would look like:

Figure 3

Results

Below is the results of the scan along
with the closing price three days after the scan was run.

Like the scan in the first article, we
see that momentum begets momentum but this time on the downside as 20 out of the
21 stocks produced closed lower three days later. Overall, the stocks lost over
7% of their value during this period. Be warned though, this doesn’t guarantee
that stocks produced by this scan will be lower in the futures(or stocks
produced by any other scans for that matter will follow through).

Picking The Next
Winner

Going back to 03/03/2000, we see that
many of the stocks (seven to be exact) produced by this scan are financial
related (i.e., banks, insurance). Like last time, it helps if you take the
stocks produced by the scanner and look for some sort of confirming technical
pattern. Putting the pieces together, we see that American Express (AXP),
a financial conglomerate, is a pullback from lows (a) on 03/03/2000. Notice that
the stock took out its prior lows on the following day, providing an entry for
shorting and then proceeded to drop for several days (b).

Figure 4

Again, Experiment!

Above I have shown just one scan that
could be used to find candidates on the short side. Like I said in the first
installment of this series, experiment! Make the StockScanner your own. Try
using higher or lower ADX. Increase or decrease your volume requirements. Run
scans using looser parameters to get a broad view, then increase price/volume/ADX
to whittle the list down. Again, it’s your StockScanner, use it as you
see fit.