Traders often turn to technical indicators to develop trading strategies. They might use a moving average, the relative strength index (RSI), stochastics or one of the hundreds of other indicators that have been developed over the years.
Sometimes, the indicators will work well. At other times, the indicators will be ineffective. To some traders, there appears to be no rhyme or reason as to when to expect an indicator to work. To others, the answer lies in the state of the market.
Among the first to delve into this problem was J. Wells Wilder who developed the RSI. He also developed another indicator that helps determine whether markets are trending or not. This other indicator is not as well known as RSI but could be more useful, and more profitable.
An Important Indicator: ADX
The Average Directional Index (ADX) is one of the few technical indicators that measure the strength of the trend and doesn’t look at whether the trend is up or down. This means that the value of ADX tells you whether or not the stock is trending.
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ADX does not offer any insight into the direction of the trend. In other words, a high value of this indicator tells traders there’s a trend but does not in any way indicate whether prices are moving up or down.
ADX is calculated from the Directional Movement Index (DMI) which consists of two parts, DMI plus (+DI) and DMI minus (-DI). All three of these indicators were first explained in Welles Wilder’s 1978 book, New Concepts in Technical Trading Systems.
The calculations are complex, and fortunately it isn’t necessary to calculate them. They are readily available at a number of free charting sites or in popular software packages. The formulas are shown below.
Source: Forex Indicators Guide
The default values for all of the inputs are 14 days, although any other time period can be used. Some traders take a 14-day EMA of the ADX to create a smoother version of the indicator known as ADXR. But, that step can delay signals significantly.
Simple Trading Rules For ADX
Many traders use ADX to find tradable trends. Wilder wrote that an ADX value of 25 or higher indicates a trend is underway. He noted values below 20 indicated there was no trend. Between 20 and 25 is an area where the market regime is likely changing.
Rather than continue with theory, it’s time for an example. The chart below shows the SPDR S&P 500 ETF (NYSE: SPY) with ADX in the middle of the chart. A grey horizontal line marks the 25 level. The DMI indicators at the bottom. DMI plus is shown in green while DMI minus is in red.
The chart shows a complete trading strategy. Traders can wait for ADX to move above 25 and then look to DMI for a signal. If DMI plus is above DMI minus, traders should buy. Otherwise, they can sell short or buy put options to potentially benefit from the expected down trend.
The entry signals are clear with this strategy. Exit signals can also be clear. The DMI indicators could be used to exit trades. Crossovers would indicate it was time to exit a trade. Or, traders can wait for ADX to fall below 20 before exiting.
The simplest rules might be:
- When ADX is above 25 and DMI plus is greater than DMI minus, buy.
- Exit when ADX falls below 20 or when DMI plus falls below DMI minus.
Because ADX tells us the stock is trending, that means any trend following indicator could work. A moving average could be used to develop a trading strategy when ADX is greater than 25, for example.
Putting ADX to Work
It’s possible to screen for high values of ADX at several web sites. This screen can provide the basis for trading ideas. After finding high ADX values, the trader would follow buy and sell rules.
Low ADX indicates the stock is in a trading range. This information is also useful for traders. If ADX is below 20, that tells us that indicators known as oscillators should be useful. The next chart combines ADX and RSI, using 5 days to calculate the value of the RSI to obtain more trading signals.
The chart shows a large number of trade signals based on RSI when ADX, shown at the bottom of the chart is below 20. Several of those signals were timely and accurate.
In the chart, the sell signal was given when RSI fell below 70 after rising above that level and the buy signal when RSI moved back above 30 after becoming oversold. Again, options could be used to potentially benefit from the signals.
Options with just one to two weeks to expiration could be ideal for this type of strategy. The expiration date can be matched to the indicators used. If weekly indicators are used, longer term options should be traded.
This strategy also uses Wilder’s work since RSI was another indicator that he explained in his book. The examples show that using ADX can help avoid markets that are not in synch with the chosen indicator. Trend following indicators generally work best when ADX is high and oscillators should be used when ADX is low.
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