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Futures with
ADX
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.
Disclaimer: The risk of loss in trading futures, options, stocks, and forex can be substantial. See Page 5 for more information.
Figure 1
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move quickly against the position, leading to big losses (stop loss
ADX Trend Strength Rule: When ADX is above 25, trend orders are essential). Depending on the trading plan, one might
strength is strong enough for trend trading strategies; when
ADX is below 25, avoid trend trading strategies.
Usually, the best entry is when price
first swings back near the 20 moving
Trend Trading with ADXcellence
A good friend won’t turn on you, so trends are more likely to average. I enter on pivot reversals
continue than reverse; and they seldom reverse without serving because they define a specific entry
notice. Therefore, when prices begin trending (ADX above 25),
price.
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 take off one half of the position on momentum swings away from
a specific entry price. the 20 moving average, leaving the other half to ride. One can
Trend trades are always taken in the direction of the trend. If also add to a position at subsequent swings back toward to the
a trade is entered opposite the direction of the trend, price can 20 moving average, essentially scaling into a strong trend. The
Disclaimer: The risk of loss in trading futures, options, stocks, and forex can be substantial. See Page 5 for more information.
Figure 2
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important thing is to understand the behavior of price during a when price retraced toward resistance at the 20 moving average.
trend and plan entries and exits accordingly. As always, the most Note that ADX rose above 25 and confirmed the downtrend.
important factor is managing the risk. 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
A good friend won’t turn on you, so stay directionally oriented and ADX is used for trend strength.
trends are more likely to continue It is easy to see the benefit of waiting for trend breakouts
in futures. One of the characteristics of trends is the cycling
than reverse; and they seldom between periods of low volatility (range) and high volatil-
reverse without serving notice. ity (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.
Figure 2 (Heating Oil, Daily) is an example of a downtrend In Figure 3 (Gold, Weekly), gold shows an uptrend that
breakout. ADX was low before the breakout, and a triangle pattern began in 2005. There was a period of low ADX which preceded
was drawn using trendlines on swing highs and lows. The –DMI the price breakout in late September. A crossover by the +DMI
crossed the +DMI at the same time price broke below the lower confirmed price expansion to the upside (above trendline
trendline. A short position was taken on the pivot high reversal, resistance). ADX then crossed above 25 to confirm new trend
Disclaimer: The risk of loss in trading futures, options, stocks, and forex can be substantial. See Page 5 for more information.
Figure 3
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strength. Long entries were made on pivot low reversals near Countertrend scalps are alluring when price moves off the 20
the 20 moving average support. Some entry points can be used moving average, and then starts to retrace back to it. But these
to add to an established position, scaling in as ADX and price trades are higher risk with lower reward because countertrend
show the trend can continue. swings are normally shorter than “trend” swings, which are nec-
The ADX line continued to rise above the 50 level as gold essary to extend a trend higher (uptrend) or lower (downtrend).
prices steadily increased. Trends which register a level of 50 or Further, price can quickly reverse against your position before
more are called “power trends.” They tend to rise faster and go the trade can be exited profitably.
farther. Strong ADX gives the trader increased confidence to It is better to scalp during non-trending conditions; in fact,
hold onto a position rather than bailing out too soon. that’s all you can do. When ADX declines under 25, price
usually enters a range bound period, or consolidation, where
Scalping with ADXcellence trend trading strategies will not work. This is scalp time, and
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 DMI Equilibrium Rule: When the +DMI and –DMI are
present these countertrend trades to me, and my reaction is below 25 and moving sideways, the trend has no dominant
always the same: “Why do you want to trade against the trend? direction.
What will your friends say?”
Disclaimer: The risk of loss in trading futures, options, stocks, and forex can be substantial. See Page 5 for more information.
ADX defines when and how. Scalps are based on the DMI For counterswing trades, entry is made “opposite” the direc-
Equilibrium Rule: When the +DMI and –DMI are below 25 tion of the crossing DMI. For example, if the +DMI crosses, it
and moving sideways, the trend has no dominant direction. The sets up a short. Why? Because without trending conditions, the
rule tells us that when price is not trending, trades can be taken DMI crosses are going nowhere fast; and prices will normally
safely in both directions. While inexperienced traders should pivot and reverse. Be aware that eventually one of these swings
probably avoid scalping, a few good trades will set up and are will breakout into a new trend, so entries are only made on pivot
worth considering for the skilled trader. reversals which tell us price has indeed reversed at the time we
During consolidation periods, DMI crossovers give frequent enter.
false crossover signals. They are called “false” because there is During range periods where is below 25, watch for DMI
no real change of dominance by the bulls or bears. The false crossovers. If the +DMI rises above 25, a trade sets up a short
crossovers usually occur in the midrange for price where risk on a price pivot high at resistance. If the –DMI rises above 25, a
cannot be managed well, but they do provide opportunities to trade sets up long on a price pivot low at resistance. Counterswing
scalp. I call these scalps “counterswing” trades due to the absence trades are more reliable when taken at a horizontal trendline
of trend, and because they are entered off the swing reversals drawn on previous swing highs and lows. The pivot entry can
between resistance and support. Scalps can be easily stopped out be tricky, and drilling down to an intraday timeframe will often
by the back and forth movement of price, thus I normally reduce allow a better entry. For most commodities, the 60-minute
my lot size by ½ for scalps. timeframe works well.
Figure 4
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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.
In Figure 4 (Live Cattle, Daily), four trades are marked for and resistance levels.
instruction purposes, however other opportunities existed if you Trends will remain your friends only as long as you take time
study the swings. In October, the -DMI peaked above 25 while to understand them and respect them. Don’t trade against your
ADX was low. This set up a long counterswing trade. A similar friend, or you may make an enemy for your portfolio.
trade setup can be seen in January.
In contrast, +DMI peaks above 25 occurred in October and Dr. Charles B. Schaap is the author of
January, setting up two short counterswing trades. During low ADXcellence—Power Trend Strategies (2006).
ADX periods, price will swing back and forth across the 20 He is a director of the Hedge Fund Association.
moving average as seen in Figure 5. In strong trends, price will Dr. Schaap lectures at the International Traders
spend about 80% of the time on only one side of the 20 moving Expo and other investment organizations. He
average (see Figures 2 & 3). has written numerous articles for magazines and
newsletters, including Technical Analysis of Stocks
Friendship Ending & Commodities, SFO, Working-Money, and Medical
Because futures contracts (and futures options) expire within a
Economics. He publishes a weekly newsletter
given time period, it is all the more important to enter trend
(www.ADXcellence.com) highlighting ADX trades.
trades when the trend is active and confirmed. Sitting in range
bound prices is a poor return on investment and exposes capital Dr. Schaap also founded TraderDoc.com where
to unnecessary risk. he consults with active traders, fund managers,
The main function of ADX is to determine if prices are and investment professionals. He specializes in
trending or non-trending, so the appropriate trading strategy alternative investment strategies for stocks, options,
can be considered. One can also use ADX values to find the and futures. Dr. Schaap can be contacted at:
strongest trends to trade. In trends, entries are made on pull- traderdoc@traderdoc.com.
backs and taken in the direction of the trend. When price is
non-trending, scalps are possible in both directions off support
Disclaimer: The risk of loss in trading futures, options, stocks, and forex can be substantial. See Page 5 for more information.