ADX[1]

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by: Dr. Charles B. Schaap

M

ost every trader has heard the adage “The trend is your friend.” But you’ve also got to know who your friends are. The ADX indicator will tell you.

In my book, ADXcellence—Power Trend Strategies, I focused mainly on trading the most powerful trends in stocks. Consequently, traders often ask me if the ADX indicator can be used to trade futures. My response is always the same: “A chart is a chart, and ADX works great on anything that trends.” However, it is important to identify the best trending timeframe for any given market.

The most important feature of ADX is that it gives an objective value for trend strength. A trader does not have to guess whether the trend “looks” strong or weak. Futures and commodities with the strongest trends can be distinguished from those with weak trends. ADX also differentiates trending conditions from non-trending conditions: something which is key to choosing the proper trading strategy and timing entries for minimum risk.

ADX

Trading

Futures with

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Finding New Friends

In ADXcellence, I explain how to use ADX to identify new trend breakouts, and there are several rules for interpreting ADX and DMI signals. I also present six specific trading strategies. In this article, I will present some ADX basics, and then show how to spot new trends. In addition, I will tell how to identify scalping opportunities when markets are not trending.

The best trends arise out of periods

of price consolidation, where the

bulls and bears challenge one

another to take control.

ADX is found on many charting programs, so it’s free to use (my settings are 13 for DMI and 8 for ADX). ADX is three indicators in one: The Positive Directional Movement Indicator (+DMI), Negative Directional Movement Indicator (-DMI), and ADX (Average Directional Movement Index). ADX mea-sures trend strength and also shows trend momentum, which is helpful in the study of divergences. ADX is non-directional, so it rises during both strong uptrends and downtrends. For direction, DMI lines are used according to the DMI Direction Rule: When the +DMI is above the –DMI, the trend direction is up; when the –DMI is above the +DMI, the trend direction is down.

DMI Direction Rule: When the +DMI is above the –DMI, the trend direction is up; when the –DMI is above the +DMI, the trend direction is down.

The best trends arise out of periods of price consolidation, where the bulls and bears challenge one another to take control. The bulls and bears are never friendly to one another, so ADX tells us who is in control and how strong or weak they are. Strong DMI crossovers lead to trend dominance. In consolida-tion periods, refer to the ADX Trendline Rule: When ADX is below 25 for an extended period (>20 bars), draw trendlines on price and wait for a breakout.

ADX Trendline Rule: When ADX is below 25 for an ex-tended period (>20 bars), draw trendlines on price and wait for a breakout.

The values for ADX and DMI range from 0-100, and the three lines are plotted in the same window on a price chart. In

Figure 1 (Corn, Daily), ADX is in the bottom window. The black horizontal line is the 25 level for ADX. The blue line is ADX; red is the –DMI, and green is the +DMI.

Note how from July to September, ADX remained under 25 and moved mostly sideways. Trendlines can be drawn on price to define resistance and support which form a triangle. There was a +DMI crossover September, confirming price strength which rose off of support. The +DMI continued to rise while the –DMI fell, causing separation of the two DMI lines. This pattern suggests range is increasing to the upside and price is poised to trend.

When ADX crossed above 25, the uptrend was confirmed. It is most important to note that when price broke above re-sistance in September, the ADX and DMI lines were used to confirm the changes in price volatility. Don’t trade indicators alone. Indicators always confirm price, but price never confirms an indicator.

The 25 level for ADX is the key level to differentiate strong from weak trending conditions. This phenomenon is represented by the ADX Trend Strength Rule: When ADX is above 25, trend strength is strong enough for trend trading strategies; when ADX is below 25, avoid trend trading strategies. When ADX is high, conditions favor trend trading. When ADX is low, only smaller scalp trades are available and they are timed with DMI momentum.

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ADX Trend Strength Rule: When ADX is above 25, trend strength is strong enough for trend trading strategies; when ADX is below 25, avoid trend trading strategies.

Trend Trading with ADXcellence

A good friend won’t turn on you, so trends are more likely to continue than reverse; and they seldom reverse without serving notice. Therefore, when prices begin trending (ADX above 25), our plan should allow positions time to work rather than quick profit taking. Trend trading seeks to enter early in a new trend. Usually, the best entry is when price first swings back near the 20 moving average. I enter on pivot reversals because they define a specific entry price.

Trend trades are always taken in the direction of the trend. If a trade is entered opposite the direction of the trend, price can

move quickly against the position, leading to big losses (stop loss orders are essential). Depending on the trading plan, one might

Usually, the best entry is when price

first swings back near the 20 moving

average. I enter on pivot reversals

because they define a specific entry

price.

take off one half of the position on momentum swings away from the 20 moving average, leaving the other half to ride. One can also add to a position at subsequent swings back toward to the 20 moving average, essentially scaling into a strong trend. The

Chart courtesy of Track ‘n Trade Pro. Visit www.TracknTrade.com for a FREE Trial!

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important thing is to understand the behavior of price during a trend and plan entries and exits accordingly. As always, the most important factor is managing the risk.

A good friend won’t turn on you, so

trends are more likely to continue

than reverse; and they seldom

reverse without serving notice.

Figure 2 (Heating Oil, Daily) is an example of a downtrend breakout. ADX was low before the breakout, and a triangle pattern was drawn using trendlines on swing highs and lows. The –DMI crossed the +DMI at the same time price broke below the lower trendline. A short position was taken on the pivot high reversal,

when price retraced toward resistance at the 20 moving average. Note that ADX rose above 25 and confirmed the downtrend. This is a good example of the non-directional nature of ADX – as price fell, ADX rose. This might seem backwards if one is new to the ADX indicator. That is why DMI lines are used to stay directionally oriented and ADX is used for trend strength.

It is easy to see the benefit of waiting for trend breakouts in futures. One of the characteristics of trends is the cycling between periods of low volatility (range) and high volatil-ity (trend). These alternating contraction and expansion cycles repeat over and over, but one must be patient to wait for the best setups. Waiting for specific setups helps reduce risk to capital.

In Figure 3 (Gold, Weekly), gold shows an uptrend that began in 2005. There was a period of low ADX which preceded the price breakout in late September. A crossover by the +DMI confirmed price expansion to the upside (above trendline resistance). ADX then crossed above 25 to confirm new trend

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strength. Long entries were made on pivot low reversals near the 20 moving average support. Some entry points can be used to add to an established position, scaling in as ADX and price show the trend can continue.

The ADX line continued to rise above the 50 level as gold prices steadily increased. Trends which register a level of 50 or more are called “power trends.” They tend to rise faster and go farther. Strong ADX gives the trader increased confidence to hold onto a position rather than bailing out too soon.

Scalping with ADXcellence

While ADX is a great trend indicator, it can also be used for short-term swing trades, or “scalps.” In general, scalping against the trend is a high risk, low reward endeavor. Traders sometimes present these countertrend trades to me, and my reaction is always the same: “Why do you want to trade against the trend? What will your friends say?”

Countertrend scalps are alluring when price moves off the 20 moving average, and then starts to retrace back to it. But these trades are higher risk with lower reward because countertrend swings are normally shorter than “trend” swings, which are nec-essary to extend a trend higher (uptrend) or lower (downtrend). Further, price can quickly reverse against your position before the trade can be exited profitably.

It is better to scalp during non-trending conditions; in fact, that’s all you can do. When ADX declines under 25, price usually enters a range bound period, or consolidation, where trend trading strategies will not work. This is scalp time, and

DMI Equilibrium Rule: When the +DMI and –DMI are below 25 and moving sideways, the trend has no dominant direction.

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ADX defines when and how. Scalps are based on the DMI Equilibrium Rule: When the +DMI and –DMI are below 25 and moving sideways, the trend has no dominant direction. The rule tells us that when price is not trending, trades can be taken safely in both directions. While inexperienced traders should probably avoid scalping, a few good trades will set up and are worth considering for the skilled trader.

During consolidation periods, DMI crossovers give frequent false crossover signals. They are called “false” because there is no real change of dominance by the bulls or bears. The false crossovers usually occur in the midrange for price where risk cannot be managed well, but they do provide opportunities to scalp. I call these scalps “counterswing” trades due to the absence of trend, and because they are entered off the swing reversals between resistance and support. Scalps can be easily stopped out by the back and forth movement of price, thus I normally reduce my lot size by ½ for scalps.

For counterswing trades, entry is made “opposite” the direc-tion of the crossing DMI. For example, if the +DMI crosses, it sets up a short. Why? Because without trending conditions, the DMI crosses are going nowhere fast; and prices will normally pivot and reverse. Be aware that eventually one of these swings will breakout into a new trend, so entries are only made on pivot reversals which tell us price has indeed reversed at the time we enter.

During range periods where is below 25, watch for DMI crossovers. If the +DMI rises above 25, a trade sets up a short on a price pivot high at resistance. If the –DMI rises above 25, a trade sets up long on a price pivot low at resistance. Counterswing trades are more reliable when taken at a horizontal trendline drawn on previous swing highs and lows. The pivot entry can be tricky, and drilling down to an intraday timeframe will often allow a better entry. For most commodities, the 60-minute timeframe works well.

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In Figure 4 (Live Cattle, Daily), four trades are marked for instruction purposes, however other opportunities existed if you study the swings. In October, the -DMI peaked above 25 while ADX was low. This set up a long counterswing trade. A similar

trade setup can be seen in January.

In contrast, +DMI peaks above 25 occurred in October and January, setting up two short counterswing trades. During low ADX periods, price will swing back and forth across the 20 moving average as seen in Figure 5. In strong trends, price will spend about 80% of the time on only one side of the 20 moving average (see Figures 2 & 3).

Friendship Ending

Because futures contracts (and futures options) expire within a given time period, it is all the more important to enter trend trades when the trend is active and confirmed. Sitting in range bound prices is a poor return on investment and exposes capital to unnecessary risk.

The main function of ADX is to determine if prices are trending or non-trending, so the appropriate trading strategy can be considered. One can also use ADX values to find the strongest trends to trade. In trends, entries are made on pull-backs and taken in the direction of the trend. When price is non-trending, scalps are possible in both directions off support

and resistance levels.

Trends will remain your friends only as long as you take time to understand them and respect them. Don’t trade against your friend, or you may make an enemy for your portfolio.

Dr. Charles B. Schaap is the author of

ADXcellence—Power Trend Strategies (2006).

He is a director of the Hedge Fund Association. Dr. Schaap lectures at the International Traders Expo and other investment organizations. He has written numerous articles for magazines and newsletters, including Technical Analysis of Stocks

& Commodities, SFO, Working-Money, and Medical Economics. He publishes a weekly newsletter

(www.ADXcellence.com) highlighting ADX trades. Dr. Schaap also founded TraderDoc.com where he consults with active traders, fund managers, and investment professionals. He specializes in alternative investment strategies for stocks, options, and futures. Dr. Schaap can be contacted at: traderdoc@traderdoc.com.