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ADX DMI Day Trading Strategy | How To Use The ADX Indicator
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Hello guys, in this video we’ll discuss about the ADX indicator, more specifically
how to correctly analyze its signals, how to analyze the market by taking into account
the ADX and we’ll also see some interesting trading strategies for Forex and stock market,
using this indicator.
The Average Directional Movement (or the ADX) is an indicator that measures trend strength
and shows trend direction.
Basically, the ADX tells traders whether the bulls or the bears are in control on the market.
The ADX is an oscillating indicator, displayed as a single line, ranging from 0 to 100.
The ADX only indicates the strength of the trend and does not indicate its direction.
In other words, the ADX is non-directional, meaning that it measures the strength of a
trend, but doesn’t distinguish between uptrends and downtrends.
So, during a strong uptrend, the ADX rises and during a strong downtrend, the ADX also
rises.
Here is how you correctly read what ADX is saying about the market.
Here are 5 aspects regarding the interpretation of the ADX:
When ADX (the blue line) is above 25, trend strength is strong enough for strategies involving
trend following In this example, we see the ADX line crossing
the 25 threshold, indicating a strong bull market.
Usually, once the ADX gets above 25 this signals the beginning of a trend.
Big moves (upwards or downwards) tend to happen when ADX is right around this number.
Of course you can experiment with this number, some traders that want faster signals, tend
to use a 20 threshold when trading with the ADX.
Here’s an example, on the aussie dollar chart, of a trade based on the 20 threshold.
The ADX line breaks above this level as the price continues its upward movement.
Remember, ADX is non-directional, so its line above 25 also indicates strong downtrends,
like in this example.
If you want a faster signal, use a 20 level for the ADX line, like in this EUR/USD chart.
When ADX is below 25, traders must avoid trend trading strategies as the market is in accumulation
or distribution phase Here’s a EUR/JPY chart, with the ADX line
below 25.
We can clearly see the lack of a trend, as the price basically trades within a range.
In this other chart, ADX crossed below 20, signifying the end of the trend or, better
said, the movement in non-trending zone.
So, when we see the ADX line below 20 or 25 level, we forget about trend trending strategies
and we apply strategies suitable for a ranging markets.
When ADX is above 25 and Positive Directional Movement Indicator (+DMI) is above the Negative
Directional Movement Indicator (-DMI).
ADX measures the strength of an uptrend.
Here’s an uptrend on the pound yen pair.
Observe the crossover between the 2 Directional Movement Indicator, as the ADX line is well
above 25.
This resulted in an excellent bullish move.
The same example on the Netflix daily chart.
The Positive Directional Movement Indicator (+DMI) above the Negative Directional Movement
Indicator and the ADX above 25 signals a strong upward trend.
When ADX is above 25 and Positive Directional Movement Indicator is below the Negative Directional
Movement Indicator, ADX measures the strength of a downtrend.
Here’s a downtrend on the Dax index.
The Negative Directional Movement Indicator crossed above the Positive Directional Movement
Indicator and once the ADX line stabilized above 25, we were safe to search for short
opportunities.
And here we have another example, on the EUR/USD.
The bears are in complete control of the market, as the Negative Directional Movement Indicator
is above the Positive Directional Movement Indicator and the ADX line rose to 50 threshold.
Which leads us to the final interpretation of the ADX.
Values over 50 of the ADX indicate a very strong trend
Check out this chart.
Look at the ADX line, hitting the 50 level.
This implies a very strong bull rally.
These movements are rare, but they do happen.
Before we get into the trading strategy we’ll use, let’s consider the pros and cons of
using this indicator.
So, why is the ADX useful for traders: First, is excellent at quantifying trend strength
Also, it allows traders to see the strength of bulls and bears at the same time Is good
at filtering out trades, during accumulation periods and Is good at identifying trending
conditions But the Adx also has its limitations.
The most important disadvantage is the fact that ADX is a lagging indicator that follows
the price, so we must be very careful when we apply this indicator, because we might
miss the inception of the trend and join it when it’s nearly over.
Also, it offers many false signals when used on shorter timeframes, so it’s advisable
to trade it on higher timeframes Also, the ADX does not contain all of the
data necessary a for proper analysis of price action, so it must be used in combination
with other tools or indicators.
Now that we fully covered the good and the bad regarding ADX, let’s see how we can
we use it in a trading strategy.
The trading strategy involves a DMI crossover, confirmed by the On Balance Volume
As we previously saw, a common way to take entries with the ADX indicator is by spotting
the DMI crossovers: the +DmiI green line crossing above the –DmI
red line, suggest an uptrend.
the +DmI green line crossing below the –DmI red line, indicates a downtrend.
However, this setup alone is not enough to be profitable and will offer a lot of false
signals.
I prefer to filter the entries with the on balance volume.
On Balance Volume (OBV) is a momentum indicator that relates volume to price change.
Basically, the OBV shows if the market’s volume is flowing into or out of an instrument
(whether is a stock, a currency or an index).
We apply a 100 simple moving average to the OBV to determine the bullish and bearish momentum
on the market and we search for trades when the 2 indicators are indicating the same thing.
Here’s an Apple chart, on the 4hour time frame.
First we determine the trend using the OBV and the 100 SMA.
During this period we observe that we have 3 crossovers (2 uptrends and one downtrend).
Once we determined the main trend, we use ADX crossover as a tool for our entries.
We have our first buy signal here, another one here, another one after this gap ( which
coincides with a solid breakout), 2 choppy signals around this area and one final buy
signal here, before the OBV turned into sell mode.
After the OBV and 100SMA crossover, we switched to bearish setups.
We have a short entry here, another one here and a choppy trade here.
The momentum switched to the upside, and we start searching for long entries.
Here’s our first buy signal around this area, and another entry here (and we are currently
in bullish mode).
Let’s look at another example, on the Dow Jones Index.
We immediately spot 3 major momentum changes.
First, we have a long signal here, a great short here, a losing trade here, an excellent
buy around this area and another buy here.
This strategy is efficient on higher timeframes and on instruments with some volatility and
high average true range.
So, don’t trade this setup on ranging markets or instruments with low volatility, because
you will get something like this on your charts.
Also, trade management is an important issue.
There are many possibilities for trade management, depending on the personality and the details
of the exact trading plan.
I personally go for a 2:1 or 3 to 1 risk reward ratio, when I’m trading stocks that have
good volatility.
I like this strategy because you are trading in the direction of a strong trend, which
reduces risk and increases profit potential.
One last thing, price is the single most important signal on a chart.
Read price first, and then read ADX in the context of what price is doing.
Use ADX to determine whether prices are trending or non-trending, and then use the trading
strategy to trade in the direction of the trend.
After all, the best profits come from trading the strongest trends and avoiding range conditions.
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Until next time.
