Trading With ADX

Posted: July 31, 2014 in General

ADX is a directional movement indicator developed by Wilder in 1978. Although it is a directional movement indicator, ADX is non-directional; meaning it will measure the strength of a trend regardless of whether the trend is up or down. In other words, ADX doesn’t express the direction of the trend; it only denotes the trend strength. A trend can either be uptrend or a downtrend, it just tells you how strong the current trend is!

ADX can be a very good indicator to choose between a trending stock and a non-trending stock. Even better, it can be great indicator to spot beginning of a trend. ADX, like RSI, also ranges between 0 to 100. ADX below 30 denotes that the stock is not in any trend and is most likely in trading range, most likely just chopping around sideways. ADX once above 30 generally means that the stock is in beginning of a trend. And once it crosses 35-40, it is said to be in a strong trend. ADX above 60 generally indicates the exhaustion of the trend and likelihood of trend fizzling out soon.

ADX lags a bit as a indicator, i.e., a trend must be in place before the ADX will denote that the trend is underway. ADX is most widely used a filter to scan stocks that are at the start of a trend. Used along with RSI, ADX can give great trading opportunities for trend following traders.

Study of ADX to evaluate and spot trends can help traders to choose the strongest trends and let profits run when the trend is strong.

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Relative strength index, or as commonly called, RSI, is a momentum based oscillator developed by J. Welles Wilder, Jr.

RSI is used to determine trend reversal opportunities in a market. Like other technical indicator oscillators, RSI is also used to measure markets being oversold or overbought. RSI being a momentum based oscillator operates on a scale of 0 to 100. The closer RSI is to 0, the more oversold the stock is said to be and the closer it is to 100, the overbought it is. As a rule of thumb, if RSI drops below 30, it implies a oversold stock or that the bear run is near its end; conversely, RSI above 70 suggests an overbought or weakening bull market.

But, immediately selling when the RSI is above 70 or buying when the RSI is below 30 can be a risky trading system. A move to these levels is better utilized if used as a signal for determining market/stock top or bottom. But it does not, in itself, indicate a top or a bottom.

The RSI chart exhibits chart formations as well. Common bar chart formations readily appear on the RSI study. They are trend lines, head and shoulders, and double tops and bottoms. In addition, the study can highlight support and resistance zones.

Different Ways of Using RSI:

  • As discussed before, RSI usually tops above 70 and bottoms out below 30. It forms these tops and bottoms usually before the price chart.

Over Sold

IfRSI(CLOSE, 14) < 30 = Normal Over Sold
IfRSI(CLOSE, 14) < 20 = Semi Strong Over Sold
IfRSI(CLOSE, 14) < 10 = Strong Over Sold

Over Bought

IfRSI(CLOSE, 14) > 70 = Normal Over Bought

IfRSI(CLOSE, 14) > 80 = Semi Strong Over Bought
IfRSI(CLOSE, 14) > 90 = Strong Over Bought

  • Also as shown above, the RSI also forms chart patterns such as double tops and bottoms, head and shoulders and others which may or may not be visible on price chart.
  • Another good way of using RSI is using crossovers of RSI and RSI average.
  • Failure Swing:

Failure swings are nothing but Support or Resistance zones’ penetrations and breakouts. This is where the RSI surpasses a previous high or falls below a previous low.

  • Divergence:

When there is a difference between what the price action is indicating and what RSI is indicating, it is said that RSI Divergence occurs. These differences are strong signs of reversals.

  1. Bullish RSI Divergence – When price makes a new low but RSI makes a higher low.
  2. Bearish RSI Divergence – When price makes a new high but RSI makes a lower high.3

Wilder believed that Bearish divergence creates a selling opportunity while Bullish Divergence creates a buying opportunity.

For a long time now, RSI has proved to be extremely valuable for any serious technical analyst.But, it has to be said that assuming which direction market will go based on just look at RSI number is a sign of novice trader rather than professional trader. One should always research and experiment with the indicator according to one’s own style of trading before relying on it as a sole decision maker for trading.

But, when used in proper perspective, RSI has proven to be a core and reliable indicator.

 

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