By Dianne L. Fecteau
Knowing whether the market is trending or moving sideways can help a trader determine what type of system they should use to enter trades. For example, if the market is choppy with lots of sideways action, entering a Forex trade based upon a trend following system such as moving average crossovers can result in the trade being quickly stopped out.
The ADX indicator is useful for determining market conditions. Developed by Wells Wilder, it uses the directional movement of price to determine its value. The calculation compares the trading range for one day to the trading range on the previous day. If the high for the current day exceeds the high for the prior day, there’s positive directional movement. If the low for the day is lower than that of the prior day, the result is negative directional movement. By then calculating the absolute difference between the two values and dividing by the sum of the two, Wilder determined whether the market was trending or not. Generally, if the ADX is above 20 the trader can use a trend following system. If it’s below 20, other approaches, such as range trading, are generally more profitable.
On the Euro daily chart below, I’ve drawn a solid red line across the indicator to mark the 20 level. I’ve used arrows to show where the ADX moved above or below this level. I’ve also drawn trend lines and support and resistance lines to mark the ranges. It’s not perfect but the value does tend to increase when the trend is strong and decreases during choppier price movement. For example, at the point I marked “A-Buy” the trader could use a moving average crossover or some other type of trend following system to enter long. During the ranges, the trader can buy support and sell resistance until the ADX line moved above 20 again.
Other clues about trend can be determined by examining the directional movement lines themselves. The green line is for positive directional movement; the red line is for negative directional movement. Note that prior to the point I marked “A – Buy”, the green line moved above the red line. This suggests the trend is moving upward, making the buy when ADX crossed over 20 a safer trade.
Note, too, that after this crossover, the positive, green line stays above the negative, red line for some time. In addition, the ADX line peaked well above both lines, at a higher level than it had previously achieved. I’ve marked the peak of the ADX line with the number “1.” It occurs shortly after the peak in price at 1.4339. The ADX line then turns downward and price enters a range-bound area within the upward trend. The two directional movement lines move closer to each other during this generally choppy price movement as opposed to the larger difference between the two when the price was climbing upwards. In fact, although the trend has been, and remains, up in the Euro, there have been a series of ranges within this upward trend. Had the trader entered at point A, they likely would have been stopped out during this period. They then could have switched to range type trading. At the point marked “B”, the ADX moved above 20 and the green directional line has moved a greater distance away from the red line. This makes a long trade a safer entry.
In summary, the rules for using the ADX indicator are:
1) Examine the ADX value itself. If it’s greater than 20, one can generally assume that price is trending, particularly if it’s moving in the direction of the prevailing directional movement indicator.
2) If the ADX line turns downward after peaking above both directional movement lines (or upward after dipping below both), this suggests a peak in the trend. The trader can expect at least a sideways period but not necessarily trend reversal. You see this at the point I marked with the number “1’.
3) When a directional movement line reaches an extreme level, the trend will often slow down. It also may reverse. You see this at the point I marked with the number “1’.
4) When the two directional movement lines move closer together, examine price action carefully. Often the two lines will meet and then part in the direction of the original trend as they do at point 2 on the indicator. Other times, they cross over each other, indicating a possible trend reversal. I’ve marked such a point with the number “3”. Wilder suggested that when the lines meet, the trader could place a buy or sell order above or below the crossover point. (Note that you don’t trade just because the lines cross over). In the case of the Euro, the low at the crossover point was 1.4771. The trader could place a sell order below that point. Deciding where that order should be can be tricky. However, assume you decided on 50 pips below (1.4721). The price was touched and continued down to 1.4683. You could have moved your stop to breakeven or slight profit before it reversed. If you had not done so, your loss would still be limited to that 50 pips.
The ADX technical indicator is useful for gauging market conditions and for signaling peaks in trends where the market may then move sideways. The trader should never use only one indicator to enter a trade. However, ADX can provide confirmation based upon other evidence to help a trader time his or her entries. As always, the trader should consider the risk and reward and use stops to limit losses.
© Dianne Fecteau, 2009.
By Dianne L. Fecteau