ADX
Trading
Futures with
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.
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 measures 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 consolidation 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 extended 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 resistance 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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Disclaimer: The risk of loss in trading futures, options, stocks, and forex can be substantial. See Page 5 for more information.
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Figure 1
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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
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Figure 2
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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 volatility (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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Figure 3
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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 necessary 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 direction 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.
Figure 4
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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 pullbacks 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.
PitNews.com Magazine March 2007
Disclaimer: The risk of loss in trading futures, options, stocks, and forex can be substantial. See Page 5 for more information.
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