… or more specific: trend strength rising from the ashes!
Trading with the Average Directional Movement Index (ADX)
Hello everyone and welcome to my blog post about the ADX. I will give you a short summary of how the ADX is specified. For a detailed explanation of what the ADX is and how it is calculated I will refer to another website: ADX explained.
In short, the ADX measures trend strength with calculations based on the moving average of price expansion over a specific period of time, default is normally at 14 periods or bars. Therefore it is non-directional. It is plotted as a line ranging between the values 0 to 100. I’ve never come across an ADX that isn’t plotted without two additional lines, called the directional movement indicators (DMI+ and DMI-). And no, I don’t have a clue how the ADX is exactly calculated and to be honest – I don’t really care nor have I needed to know as of yet 😉
How do I use the ADX
Phoenix Rising – ADX or trend strength rising from the ashes.
The ADX is shown in this picture; the green line is the DMI+ (price is going up), the red line is the DMI- (price is going down) and the blue line is the actual ADX. The horizontal green line I’ve plotted on myself at a value of 25. All activity of the price BELOW the 25 horizontal line I refer to as the trend being in the ashes. The moment the blue line (ADX) rises from the ashes and crosses the 25 horizontal line, thats the moment when you have to wake up. Why? Because this can indicate that price movement is on its way. And that is, after all, what we are looking for.
The sky blue line in the chart is the 200 SMA, and the deep pink line is the 20 EMA. The price below the 200 SMA is bearish, the price above it is bullish. If you look closely, you will see that the ADX makes little and bigger spikes. These spikes are accompanied by either the DMI+ (green) or DMI- (red). As long as the ADX is UNDER the 25 horizontal line, you sit on your hands and WAIT. When the ADX moves above it, you watch closely whether this upward move is accompanied by the DMI+ or DMI-.
Here and now, we ONLY look for bearish opportunities, since we are in a DOWN TREND, both on this timeframe (5 minutes) as well as on the 1H (one hour) timeframe, not shown here. On the left side of the image, the price comes from bullish momentum (which was a retracement), crossing the 200 SMA down, creating bearish momentum. Thats the moment we have been waiting for! That first wave down, the cross of the 200 SMA down, is a trading opportunity you will pass up. After its initial swing down, there is a little pull back, with price coming down further. As stated above, everything happening below the 25 line, is (tr)ash. Therefore I wouldn’t have taken the last little swing down, since the cross over of the DMI- above the DMI+ happened with the ADX being in the ashes. Furthermore and very important: after this last little swing down, I have a lower low, but my ADX made a lower spike, indicating that the strength or power behind that little last move down was way less than the initial power behind the initial swing down. This is called DIVERGENCE and it is a good indicator for a retracement or a pull back of the price to come.
Lets move further to the right of the image. After this last little push down, the ADX spikes up above the 25 line 4 times and moves back into the ashes again. Every single time the spike is initiated or accompanied by the green DMI+. No entries for a bearish trade there. BUT the fourth time something else happens. The fourth spike above the 25 line is initiated by a bullish move (DMI+ green line), the ADX returns to the ashes, but immediately bounces off the 25 line. At that same moment, the red DMI- crosses ABOVE the green DMI+, indicating a movement that is strong enough and getting stronger AND a movement in the direction of OUR trend.
Place your sell at the market! Stop loss a couple of pips above the high of the U-turn (watch the spread and your “ask” line, so you won’t get pushed out for no reason). Target a 1:3 risk vs reward. Or as shown here, the moment the ADX tells you a retracement is likely to happen. In this case there was a cross over of the DMI+ above the DMI-, with the ADX being above the 25 line, which for me is a reason to exit the trade. Reward? 20 pips!
And indeed, there was a retracement.
I’ve highlighted with the dark blue vertical line the next opportunity, according to the ADX and the strategy. And this is the reason why trendlines are important. In this case we had a spike of the ADX above the 25 line initiated/accompanied by the DMI-. Nice!! Retracement is over and we are going down again. BUT the candlesticks didn’t close below the trendline with their bodies. Their tails (wicks) did, so price did go under the trendline, but you always have to wait for the closing of a candle stick. And only then when the body closes, preferably more than 50% of its body, below the trendline (in a down trend) you have a valid entry. This was not the case and you saved yourself from a losing trade.
The ADX breaks above the 25 line again, initiated by the DMI+, BUT with a cross over of the DMI- above the DMI+, with the ADX ABOVE the 25 line. This momentum coincides with the break of the initial trendline. Again place your stoploss a couple of pips above the high of the U-turn, target 1:3 or when the ADX shows a retracement is probably on its way. Result: 28 pips.
Getting bored already? 🙂 Reason for this third entry is the spike up of the ADX ABOVE the 25 line, and this time initiated by the DMI-. If you watch closely, you can also see a big difference between the spikes created on the ADX with the three preceding up pushes. The first push up being a pretty big spike, second and third hardly detectable. Thats confirmation and adding to our confidence to take this selling opportunity. Again place your stoploss a couple of pips above the high of the U-turn and target 1:3 or when evidence suggests a retracement. And also in this case we have a cross over of the DMI+ above the DMI- with the ADX still being above the 25 line. Result: 42 pips.
In approximately 24 hours you were able to gain 90 pips on the 5 minute chart. 3 trades, 3 wins. Is this always the case? No unfortunately not. There is the odds game again. In this situation we were in a nice down trend. All charts aligned, the 5 minutes, the hourly AND the daily were in a downtrend. This is ideally what you want. To enter in a direction, the minimum requirement for me is the 1 hour and the timeframe I am trading from (usually the 5 minutes) are aligned in the same direction. Meaning, I want the price to move below the 200 SMA on the hourly chart to look for bearish trades on the 5 minutes chart and I will look for bullish trades on my 5 minutes chart when the price is above the 200 SMA on the hourly.
So remember, for a solid entry the ADX has to rise from the ashes and needs to be accompanied by the right DMI, depending on trend direction. OR it initially rises from the ashes with the “wrong” DMI, but then the cross over has to happen with the ADX being ABOVE the 25 horizontal green line. Another important note: strategies like these are not timeframe bound. They will work on any timeframe, you just have to make sure that you trade in line with a higher timeframe. AND always back test it. Look what it did the last couple of days, did it give solid and profitable trades? Or is the market in consolidation and are you better of with for instance the RSI or Bollinger bands? Or leave the currency pair for what it is and wait until there is enough evidence it entered a trending phase again.
I hope you enjoyed this post! For now I will leave you and wish you all HAPPY SUCCESSFUL TRADING! 🙂