A lesson in Trading ADX…

Today I'm going to discuss how we can take help of ADX to trade. Firstly let us understand what ADX means and what it indicates. This indicator has been created by Welles Wilder and he had created this to measure the actual strength of the market whether bullish or bearish.  I will not go into the calculations as to how ADX is calculated and plotted and unnecessary complicated our life. Well ADX is not an oscillator in the real sense. It does not move about mean line like perhaps the slow stochastic and MACD or RSI. It is generally plotted as three lines. The first one being black and that indicates the strength of the move. For example if the market is trending up and this black line is also going up it indicates that the uptrend is strong. I'll come to exact facts and figures a little later.

Apart form this there are two additional lines the +DI and the –DI. The +DI lines is also called the Positive Directional Index and the –DI lines is also called the Negative directional index line. Also the +DI is generally green in colour and the –DI line is generally red in colour. If the Black or the ADX indicates the strength or weakness then the +DI and –DI indicate the sellers having the upper hand or the buyers having the upper hand or vice versa. Or let me put it this way

• The +DI line represents how strong or weak the uptrend in the market is.
• The –DI line represents how strong or weak the downtrend in the market is.
• As the ADX (Black Line) is comprised of both the +DI and –DI lines, it does not indicate whether the trend is up or down, but simply the strength of the overall trend of the market.

Before I move forward I would once again repeat that as explained above the ADX line is non directional, it does not tell you whether the market is in an uptrend or down trend – but as to how strong or weak the trend in the stock or index you are analysing is. If you have understood this part then also know that generally when the ADX line is above 40 and rising – this is indicative of a strong trend and if ADX line is below 20 and falling this is indicative of a ranging market. These figures are for reference only and some people tend to use the 25 and 35 figures for the range bound market and trending market respectively. So I suggest you pick up default values and live with them.

So far so good? Now we will try to see how it can be traded. The ADX can be traded in three ways. Pardon my saying that I might like to put it this way that I will not try to trade ADX in all three way but in first scenario I will trade it and in the other two scenarios I will trade a trend or a non trend for that matter.

• Firstly, and most importantly we trade the +DI and / –DI crossovers. Let me put it more simply. If we have the +DI (the green line) cross over above the –DI (the red line) then I buy. If the –DI line crosses over the +DI line then I sell. I also see this with respect to the ADX line – that is to say if during these crossovers the ADX (the black line) is below the 20 mark then the market is not trending and this could be a misinterpretation of the signal. how ever if in the same circumstances the ADX line was above 20 and climbing – then it could indicate that you have caught the trend correctly and you may be able to ride it well.
• Like I said before the second and the third are trading the trend or lack of trend. So let us see. If there is a lack of trend then we would like to see the the range of the markets in which they are caught up. In this case it is best that we take help of some other indicator. Bollinger Bands are good indicators when the markets are not trending. So generally the range of the market would be between the  bands – so it may be safe to sell naked options – calls when the markets are around the top of the band and sell puts when around the bottom of the Bollinger bands. The stop loss can be a point just outside the band with the ADX crossing above – say 30! Actually this point has to chosen by you and you alone. My figures are a suggestions only.
• The third is Trading weakness in trend. It is different from a range bound market. Weakness in trend may be taken on an anticipation of trend reversal. So partly buying when the down trend is weakening followed by entering with conviction when the +DI crossover above –DI may be a good strategy.

Along with this we can use the ADX for entry and exit also. Let us assume that you entered the stock when the +DI crossed above the –DI and the trend is gaining strength (ADX moving above 20/25) we would have entered. Now if +DI crosses and goes above the ADX line reinforces the decision taken. ADX moving below 40 may mean a pullback from the trend.

I did not have too much time as my commitments during this leave are keeping me busy so I have used only a few charts for examples – so please pardon me for that.

Also it is very important to remember that ADX or for that any technical indicator must be used in conjunction with some other indicator to reinforce and should not be made use of singularly to take decisions. Please feel free to leave comments – will try to answer if there are queries.