You are on page 1of 7

T rading F with utures

ADX
by: Dr. Charles B. Schaap

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.

M

draw trendlines on price and wait for a breakout. the trend direction is down. when the –DMI is above the +DMI. ADX remained under 25 and moved mostly sideways. The values for ADX and DMI range from 0-100. ADX is non-directional. and forex can be substantial. There was a +DMI crossover September. In consolidation periods. In addition. I explain how to use ADX to identify new trend breakouts. conditions favor trend trading.In ADXcellence. It is most important to note that when price broke above resistance in September. the trend direction is up. When ADX is high. Daily). See Page 5 for more information. avoid trend trading strategies. For direction. and then show how to spot new trends. Don’t trade indicators alone. red is the –DMI. stocks. The black horizontal line is the 25 level for ADX. when ADX is below 25. Trendlines can be drawn on price to define resistance and support which form a triangle. causing separation of the two DMI lines. so it’s free to use (my settings are 13 for DMI and 8 for ADX). DMI Direction Rule: When the +DMI is above the –DMI. where the bulls and bears challenge one another to take control. I also present six specific trading strategies. but price never confirms an indicator. and the three lines are plotted in the same window on a price chart. When ADX is low. the trend direction is up. The best trends arise out of periods of price consolidation. DMI lines are used according to the DMI Direction Rule: When the +DMI is above the –DMI. Strong DMI crossovers lead to trend dominance. I will present some ADX basics. and green is the +DMI. confirming price strength which rose off of support. Finding New Friends The best trends arise out of periods of price consolidation. ADX is in the bottom window. In this article. which is helpful in the study of divergences. where the bulls and bears challenge one another to take control. This phenomenon is represented by the ADX Trend Strength Rule: When ADX is above 25. refer to the ADX Trendline Rule: When ADX is below 25 for an extended period (>20 bars). options. and ADX (Average Directional Movement Index). ADX measures trend strength and also shows trend momentum. Note how from July to September. trend strength is strong enough for trend trading strategies. The blue line is ADX. so ADX tells us who is in control and how strong or weak they are. when the –DMI is above the +DMI. The +DMI continued to rise while the –DMI fell. ADX is three indicators in one: The Positive Directional Movement Indicator (+DMI). the trend direction is down. When ADX crossed above 25. Indicators always confirm price. ADX is found on many charting programs. In PitNews. ADX Trendline Rule: When ADX is below 25 for an extended period (>20 bars). the ADX and DMI lines were used to confirm the changes in price volatility. The bulls and bears are never friendly to one another. 0 Disclaimer: The risk of loss in trading futures. . I will tell how to identify scalping opportunities when markets are not trending. This pattern suggests range is increasing to the upside and price is poised to trend.com Magazine March 007 Figure 1 (Corn. only smaller scalp trades are available and they are timed with DMI momentum. so it rises during both strong uptrends and downtrends. the uptrend was confirmed. The 25 level for ADX is the key level to differentiate strong from weak trending conditions. Negative Directional Movement Indicator (-DMI). draw trendlines on price and wait for a breakout. and there are several rules for interpreting ADX and DMI signals.

our plan should allow positions time to work rather than quick profit taking. essentially scaling into a strong trend. so trends are more likely to continue than reverse.Figure 1 Chart courtesy of Track ‘n Trade Pro. avoid trend trading strategies.TracknTrade. and forex can be substantial. Usually. leaving the other half to ride. . Depending on the trading plan. one might Trend Trading with ADXcellence A good friend won’t turn on you. move quickly against the position. I enter on pivot reversals because they define a specific entry price. See Page 5 for more information. trend strength is strong enough for trend trading strategies. and they seldom reverse without serving notice. when prices begin trending (ADX above 25). Visit www. the best entry is when price first swings back near the 20 moving average. take off one half of the position on momentum swings away from the 20 moving average. One can also add to a position at subsequent swings back toward to the 20 moving average. the best entry is when price first swings back near the 20 moving average. stocks. when ADX is below 25. Therefore. price can PitNews. Trend trades are always taken in the direction of the trend. If a trade is entered opposite the direction of the trend. options. The 1 Disclaimer: The risk of loss in trading futures.com for a FREE Trial! ADX Trend Strength Rule: When ADX is above 25. Trend trading seeks to enter early in a new trend. I enter on pivot reversals because they define a specific entry price. leading to big losses (stop loss orders are essential).com Magazine March 007 Usually.

Note that ADX rose above 25 and confirmed the downtrend. .com Magazine March 007 when price retraced toward resistance at the 20 moving average. This might seem backwards if one is new to the ADX indicator. The –DMI crossed the +DMI at the same time price broke below the lower trendline. Waiting for specific setups helps reduce risk to capital. In Figure 3 (Gold. It is easy to see the benefit of waiting for trend breakouts in futures. ADX then crossed above 25 to confirm new trend  Disclaimer: The risk of loss in trading futures. This is a good example of the non-directional nature of ADX – as price fell. There was a period of low ADX which preceded the price breakout in late September. These alternating contraction and expansion cycles repeat over and over. PitNews.com for a FREE Trial! important thing is to understand the behavior of price during a trend and plan entries and exits accordingly. and forex can be substantial. stocks. One of the characteristics of trends is the cycling between periods of low volatility (range) and high volatility (trend). Weekly). Visit www. A crossover by the +DMI confirmed price expansion to the upside (above trendline resistance).Figure 2 Chart courtesy of Track ‘n Trade Pro. and they seldom reverse without serving notice. A good friend won’t turn on you.TracknTrade. options. so trends are more likely to continue than reverse. Figure 2 (Heating Oil. ADX rose. but one must be patient to wait for the best setups. That is why DMI lines are used to stay directionally oriented and ADX is used for trend strength. gold shows an uptrend that began in 2005. A short position was taken on the pivot high reversal. Daily) is an example of a downtrend breakout. and a triangle pattern was drawn using trendlines on swing highs and lows. See Page 5 for more information. As always. the most important factor is managing the risk. ADX was low before the breakout.

scalping against the trend is a high risk. When ADX declines under 25. See Page 5 for more information. options. It is better to scalp during non-trending conditions. Traders sometimes present these countertrend trades to me. which are necessary to extend a trend higher (uptrend) or lower (downtrend). The ADX line continued to rise above the 50 level as gold prices steadily increased. Some entry points can be used to add to an established position.com for a FREE Trial! strength. Visit www. it can also be used for short-term swing trades. or consolidation. Long entries were made on pivot low reversals near the 20 moving average support. and forex can be substantial. price usually enters a range bound period. that’s all you can do. This is scalp time. and my reaction is always the same: “Why do you want to trade against the trend? What will your friends say?” PitNews. Trends which register a level of 50 or more are called “power trends. in fact. stocks.” In general. price can quickly reverse against your position before the trade can be exited profitably. where trend trading strategies will not work.” They tend to rise faster and go farther.com Magazine March 007 Scalping with ADXcellence Countertrend scalps are alluring when price moves off the 20 moving average. low reward endeavor.Figure 3 Chart courtesy of Track ‘n Trade Pro. and DMI Equilibrium Rule: When the +DMI and –DMI are below 25 and moving sideways. scaling in as ADX and price show the trend can continue. Strong ADX gives the trader increased confidence to hold onto a position rather than bailing out too soon. 3 Disclaimer: The risk of loss in trading futures. and then starts to retrace back to it. or “scalps. While ADX is a great trend indicator.TracknTrade. . Further. the trend has no dominant direction. But these trades are higher risk with lower reward because countertrend swings are normally shorter than “trend” swings.

and prices will normally pivot and reverse. The pivot entry can be tricky. watch for DMI crossovers. Scalps can be easily stopped out by the back and forth movement of price. if the +DMI crosses.com Magazine March 007 Disclaimer: The risk of loss in trading futures.ADX defines when and how. a few good trades will set up and are worth considering for the skilled trader. a trade sets up long on a price pivot low at resistance.TracknTrade. I call these scalps “counterswing” trades due to the absence of trend. For counterswing trades. Figure 4 Chart courtesy of Track ‘n Trade Pro. and forex can be substantial. the 60-minute timeframe works well. but they do provide opportunities to scalp. Visit www. and drilling down to an intraday timeframe will often allow a better entry. They are called “false” because there is no real change of dominance by the bulls or bears. While inexperienced traders should probably avoid scalping. stocks. Why? Because without trending conditions. The false crossovers usually occur in the midrange for price where risk cannot be managed well. If the +DMI rises above 25. options. For most commodities. the trend has no dominant direction. a trade sets up a short on a price pivot high at resistance. See Page 5 for more information. For example.  . and because they are entered off the swing reversals between resistance and support. the DMI crosses are going nowhere fast.com for a FREE Trial! PitNews. DMI crossovers give frequent false crossover signals. During range periods where is below 25. The rule tells us that when price is not trending. it sets up a short. trades can be taken safely in both directions. If the –DMI rises above 25. Scalps are based on the DMI Equilibrium Rule: When the +DMI and –DMI are below 25 and moving sideways. 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. entry is made “opposite” the direction of the crossing DMI. Counterswing trades are more reliable when taken at a horizontal trendline drawn on previous swing highs and lows. During consolidation periods. thus I normally reduce my lot size by ½ for scalps.

setting up two short counterswing trades. Trends will remain your friends only as long as you take time to understand them and respect them. He specializes in alternative investment strategies for stocks.com Magazine March 007 Disclaimer: The risk of loss in trading futures. This set up a long counterswing trade.  . In October. fund managers. In contrast. however other opportunities existed if you study the swings. Schaap can be contacted at: traderdoc@traderdoc. and forex can be substantial. including Technical Analysis of Stocks & Commodities.ADXcellence. Working-Money. options. options. and Medical Economics. Schaap is the author of ADXcellence—Power Trend Strategies (2006). Dr. Sitting in range bound prices is a poor return on investment and exposes capital to unnecessary risk. or you may make an enemy for your portfolio. SFO. In strong trends. Dr. stocks. A similar trade setup can be seen in January. In trends. Dr.com) highlighting ADX trades. He is a director of the Hedge Fund Association. During low ADX periods. Don’t trade against your friend. it is all the more important to enter trend trades when the trend is active and confirmed. entries are made on pullbacks and taken in the direction of the trend. Schaap lectures at the International Traders Expo and other investment organizations.com where he consults with active traders. Friendship Ending Dr. the -DMI peaked above 25 while ADX was low. +DMI peaks above 25 occurred in October and January. price will spend about 80% of the time on only one side of the 20 moving average (see Figures 2 & 3). He publishes a weekly newsletter (www. scalps are possible in both directions off support and resistance levels. Daily). When price is non-trending. The main function of ADX is to determine if prices are trending or non-trending. One can also use ADX values to find the strongest trends to trade. Charles B. Because futures contracts (and futures options) expire within a given time period. See Page 5 for more information.com. price will swing back and forth across the 20 moving average as seen in Figure 5. so the appropriate trading strategy can be considered. and investment professionals. He has written numerous articles for magazines and newsletters. Schaap also founded TraderDoc. four trades are marked for instruction purposes. and futures.In Figure 4 (Live Cattle. PitNews.