This article on Top 3 Technical Trading Strategies is the opinion of Optimus Futures.
- There are hundreds of technical indicators out there. Too many, in fact, and enough to cause ‘paralysis by analysis.’
- This post is intended to show three technical trading strategies that can offer a quick, easy, and efficient approach to trading the futures markets effectively.
- Many traders spend too much time experimenting with various technical indicators, or parameter settings. Our goal is to simplify a trader’s technical trading strategy down to three key indicators or systems.
- Candlesticks are a system on their own; frequently revealing turning points in the market.
- The Ichimoku system can reveal which direction a trend is moving, while each of its components stand out as important points of support and resistance.
- The ADX is an excellent indicator of whether the market is trending or prone to sideways price action.
Let’s begin with two simple questions:
- Can you put together a 3-piece jigsaw puzzle in 5 minutes? Of course, you can! (If you can’t, maybe futures trading is not for you ?)
- Can you put together a 100-piece jigsaw puzzle in 5 minutes? Most definitely not. (If you can, you’re likely in MENSA and should be doing other things than jig-saw puzzles.)
- Candlestick Analysis
- Ichimoku Analysis
- Average Directional Index (ADX)
Does Technical Analysis Work?
Before we begin, let’s first address a question that almost every trader asks: does technical analysis even work, and if so, why?
On one side of the spectrum, there are traders who focus strictly on economic fundamentals such as unemployment, consumer confidence, purchasing managers’ index (PMI’s), and key central banks outlooks, among others. But even these traders are likely to look at a chart or two before pulling the trigger.
On the other end, there are traders who focus strictly on technical analysis. For example, imagine a scenario in which the S&P 500 establishes a new high after several failed attempts. For some traders, this technical “breakout” may qualify as a buying signal.
They may not care why the price has broken out to a new high (though there is usually some fundamental story behind the price move); they do care about the fact that the S&P 500 has broken above “resistance” to reach this new price level.
In other words, all that matters is price and how it behaves within a certain technical context.
As a side note, price is often the primary driver of many algorithmic trading systems, which have come to play an outsized role in the markets these days. Not all algorithmic systems use fundamental data. Many use only price data interpreted through a technical perspective (e.g. is it overbought/oversold, trending/not trending) to initiate a trading signal.
Finally, in the middle of the spectrum, we have traders who look at both fundamental data and technical indicators to form their trading strategies. They may use economic data to determine whether a market is likely to rise or fall, and then employ technical analysis to identify favorable entry and exit levels.
Now let’s go back to the question of whether technical analysis works. Think back to the three trading approaches portrayed above. What do they all have in common? You guessed it–technical analysis.
In the broadest sense, technical analysis works because enough market participants rely on it to one degree or another. Some might say that technical analysis is a self-fulfilling prophecy, where enough traders take their cue from the technicals, causing price to move in the direction suggested by technical analysis, reinforcing the technical backdrop. And so on, and so on….
But on a practical level, technical analysis can provide the tactical approach needed to execute a fundamentally-driven strategy.
Another important thing to remember: technical analysis is more art than science. For instance, two traders may view the same chart and develop different opinions as to the course of future price moves. What is more, they could both be right, depending on the timeframe of the proposed trade.
One trader may be looking at the short-term while the other may be focused on the long-term. Hence, they’ll be looking at the same chart, but they’ll have two different opinions and outcomes depending on their time frame and strategy.
Last but not least, there are hundreds of technical indicators out there. Too many, in fact, and enough to cause ‘paralysis by analysis.’
This post is intended to show three technical methods that can offer a quick, easy, and efficient approach to trading the futures markets effectively–in other words, the 3- piece in 5 minutes jigsaw puzzle approach.
There are three main chart types that traders and investors commonly use: line charts, bar charts, and candlestick charts.
We prefer candlesticks because of its visual clarity. What we mean by that is a candlestick will tell you a market’s…
- opening price
- highest price
- lowest price, and
- closing price
Unlike bar charts, candlestick “bodies” are color-coded–traditionally white if the market ended higher or black if it ended lower–making market directionality much easier to see than your traditional bar.
When it comes to tracking prices and their movements, you can’t really get more specific than candlesticks as a charting method. And that’s why we prefer to use them.
Additionally, candlestick patterns can help traders see potential price action directionality in addition to finding specific entry and exit signals.
Candlesticks are the oldest form of technical analysis, having originated in the Japanese rice markets in the 18th century. Widely popular throughout Asia for centuries, candlesticks and their patterns were introduced to the West by Steve Nison and his book: Japanese Candlestick Charting Techniques.
We think it is safe to say that his book is considered the bible when it comes to learning about and practicing candlesticks analysis.
Let’s get started by illustrating the composition of a candlestick:
As you can see, candlesticks have the same Open, High, Low, Close (OHLC) info as a bar chart, but the big difference is the color and visibility of the day’s trading range, as shown by the real body, or just body.
There are a few different names to refer to the outermost elements of a candle referred to above as ‘shadows.’ They are alternately called ‘shadows’, ‘wicks,’ or ‘tails.’ For the purpose of this post, we will call them ‘tails.’ For the ‘real body,’ we’ll just call it the ‘body.’
Candlesticks can be used in any timeframe but do so at your own risk. The reason for this is that candlesticks were designed to be used in the daily time frame.
The idea is that each candle reflects all of the information that went into a full day’s worth of trading. Intra-day candles only tell us what happened during segments of the day. Hence, we’ll only focus on daily candles and the patterns that they form.
In terms of viewing candlesticks, think of them as a battle between the bulls and the bears, or the buyers and the sellers.
Just looking at the two candles above, we can see that the white candle meant the day belonged to the buyers, as the body is long and white. The second candle shows that the sellers were in control, but it also tells us much more than that.
Interpreting a Candlestick
Note the long tail on top of the dark candle.
How might we interpret this?
- The buyers had a strong run-up, exceeding its opening price to form a distant high.
- Eventually, sellers overpowered buyers, generating a dark body.
- There was some buying at the low, which is what formed the tail at the bottom.
- By the end of the day, the sellers had won.
Please note, different charting systems have different default ways of displaying the bodies of the candle, but they all reflect the same information: darkness (down)vs. light (up).
You can also use trendlines with candles, connecting the tails as you would normally connect the top or bottom of a bar chart.
There are literally dozens of candlestick patterns that will appear on charts over time. Some are single candle patterns, two candle patterns and three candle patterns. We can’t show you all of them, but we will show you the ones we think are most important and why.
As a rule of thumb, be on the lookout for small bodies and long tails, as they frequently signify strong price rejections, sometimes preceding a reversal in the current trend (up or down).
In most cases, we’ll be looking for two candle patterns, where the third candle generally provides confirmation of the two-candle pattern’s validity.
Single Candle Patterns
But let’s begin by looking at a few single candle patterns that are the most informative and frequently provide a piece of the puzzle to multi-candle patterns.
DOJI-a Doji (Japanese for ‘cross’) is a single candlestick pattern, where the open is or almost equal to the close and has small tails.
Dojis indicate that neither buyers nor sellers won out on a particular day. The trading range for a Doji is also typically small.
The important thing about a Doji is that it indicates indecision in the market.
Sometimes, that indecision can be a precursor to a change in trend direction.
A Doji commands attention when it is preceded by an up or down-trend, with the next candle showing a potential resolution: down after an up-trend/up after a down-trend.
White/Black spinning tops
A spinning top has a small body with tails that are longer than the body. It literally looks like a “spinning top,” hence its name.
A spinning top indicates that buyers and sellers each had a try to move upwards/downwards but ultimately came to a largely neutral overall day. A spinning top is similar to a Doji in that it indicates overall indecision following an up or down trend.
Traders should be alert for a coming resolution following a spinning top or a series of spinning tops.
Another type of Doji pattern, where ideally the real body is non-existent or extremely small.
The long legs indicate that both buyers and sellers were able to test each side of the market aggressively. But despite the volatile struggle, they ultimately ended in a standstill.
A long-legged Doji indicates extreme indecision in the market. Look for the next candle to provide resolution in one direction. A long-legged Doji is especially important when it follows an up or down trend, indicating a potential resolution in the coming days.
Also known as a ‘dragonfly’ Doji, the pattern should have an extremely small to no body, with a long lower tail and no upper tail. The sellers dominated for the day, but the buyers came back, driving the close back to equal the open.
An umbrella Doji indicates a bullish reversal following a downtrend; note that the buyers ultimately won out on the day following a series of declines.
The dragonfly may also indicate a bearish reversal following a move higher; note that sellers dominated throughout the day, but that the buyers could not extend higher than the open. Confirmation by the next candlestick is necessary in both cases.
Also known as an ‘inverted umbrella’ Doji, forms when a long downside tail is finished by a Doji with no lower tail.
As the name might suggest, the pattern may represent a bullish reversal following a downtrend, or a bearish reversal following an uptrend.
Note that buyers held sway during the day (a bullish sign following a downtrend), but were ultimately beaten back by selling interest (a bearish sign following an uptrend), but which could not extend the downside below the open. Confirmation by the following day’s candlestick is necessary to decide whether the market is reversing course.
As you can see, Dojis (or candles with extremely small bodies that can be viewed as Dojis) are important warning signs of a potential trend shift and should be noted well by traders whenever they appear.
Overall, dojis represent indecision in the market, but this indecision will eventually give way to a resolution one way or the other. The trend will either extend or reverse. Be prepared for action after a doji formation!
Dojis dominated the series of one-candle patterns, where they typically reveal market indecision, and thus a potential reversal of the current trend, or possibly a continuation of the trend. Confirmation by the next day’s candle is essential following any Doji-type candle.
Bullish Candlestick Patterns
Let’s now look at some other common candlestick patterns that can be made of several (2-3) candles and are more directionally relevant. While we begin with bullish reversal patterns, it is important to note that each candle pattern generally has a corollary in the negative direction
The ‘bullish hammer’ (named so because it looks like a hammer) is a major bottom reversal signal. A bullish hammer is formed with a long tail on the bottom and a small body at the top (the color of the body does not matter, but a white body would generate more of a bullish signal).
Note that the sellers had a good day with the long lower tail, but that the buyers eventually came back to close above the day’s opening. This could be a sign that the down move is ending. Traders would want to initiate a long position on a break above the hammer’s top, with a stop loss located below the bottom of the tail.
You should note that the bullish hammer is similar to the dragonfly/umbrella Doji shown before.
The main difference is the size of the body, but both patterns are potential signals a bottom has been reached.
Bullish Engulfing Line
The bullish engulfing line is a strong indicator that a bottom has been seen. Following a dark candle in the succession of a down move, a long white candle appears where the body of the white candle fully ‘engulfs’ the prior dark candle.
This can be taken to mean that the sellers had only minimal control, while the buyers ultimately dominated, creating a large white candle. In a downtrend, traders should be on the look-out for bullish engulfing candles, as they may signal not only a bottom period of consolidation but also a reversal of the down move altogether.
A bullish Harami is so named because of its relative depiction of a pregnant woman (‘Harami’ is an old Japanese word that translates to ‘pregnant.’) Following a down move, note the light candle body is inside the previous dark candle, but an open above the prior close and a test of the prior day’s high, suggests buyers have emerged and the down move may be over.
Bullish Harami Cross
The Bullish Harami cross is a strong indication that a bottom has been reached. Note the Doji following a series of dark candles, typically indicating indecision or a neutral outlook. But the Bullish Harami cross (Doji) is one of the more reliable patterns indicating the end of the move lower and potential for a reversal higher.
It is a corollary to the bullish Harami shown above, but the Doji/cross suggests the market is at the height of indecision. Think about it: the prior day was a strong dark candle followed by a Doji. The implication is that the sellers have lost control and buyers are beginning to emerge.
Bullish Inverted Hammer
A bullish inverted hammer appears with a light candle and a long tail to the top, following a series of declines.
While somewhat counter-intuitive, with the body being at the bottom of the day’s range, the important element is that the day saw significant buying, with the tail exceeding the bottom of the prior candle. Confirmation is needed by the next day’s candle to pursue this as a bullish reversal.
Bearish Candlestick Patterns
As mentioned previously, many candlestick patterns have an opposite corollary to the bullish/bearish pattern. Many of the bearish candle patterns we’re about to show will readily be seen to have their mirror opposites.
Bearish Hanging Man
As you can see, the candle has a long lower tail and a small, dark body at the top, somewhat depictive of a hanging man.
While frequently cited as a bearish pattern, one could also argue that it’s a bullish signal: note its similarity to a bullish hammer described above. As to the hanging man itself, sellers made an attempt to push prices down, but enough buyers emerged to take the price up near to the top of the day’s range.
As to the pattern itself, many practitioners of candlestick analysis view this as a potential sign of a bearish reversal. From their point of view, the sellers had a good run on the downside and managed to finish out below the opening.
So, bullish or bearish? It depends on the context and your own interpretation. Therefore, and perhaps more so than other patterns, the hanging man formation requires confirmation by the next candle to show if it is a bearish or bullish sign.
Bearish Engulfing Line
A bearish engulfing line is the mirror image of the bullish engulfing line shown before, but this time it has bearish connotations.
Following a series of up-candles and a final long white candle, the next candle is dark and completely engulfs the prior white candle.
The fact that the dark bearish candle finishes at or below the prior day’s low adds credence to the notion that this is a major reversal signal. Just as with bullish engulfing lines, traders should be alert to bearish engulfing lines, too.
Following a move lower, candles may depict the opposite of the bullish Harami (shown above). In this case, however, it’s a bearish Harami that follows a move higher. This is a major signal of an impending bearish reversal after a move to the upside. The patterns are the same, only with the colors reversed. Trading strategies can be kept fairly tight using the prior day’s range.
Bearish Shooting Star
A bearish shooting star has many of the attributes of a bullish inverted hammer shown above, except that this time it’s a downside reversal pattern after a move higher. The image of a shooting star is quite evident, suggesting that buyers attempted to take the price higher, but were firmly denied, with the price closing on the day’s low.
The longer the tail on the upside, the more the buyers were rejected and the greater confidence we have in what is a major reversal pattern.
Bearish Evening Star/Island Reversal
A bearish evening star is a strong signal of a bearish change in direction (or reversal) after a move higher.
The pattern is formed with an opening gap, followed by a battle between the bulls, leaving behind a Doji or a very small body that approximates a Doji. The pattern is sometimes referred to as an ‘abandoned baby top.’
The interpretation is that the buyers were bullish from the start, as indicated by the opening gap. Subsequent price action, however, shows that buyers and sellers came to a draw, indicating strong indecision following a directional price move.
The Bearish Evening Star/Island Reversal/Abandoned Baby top has a mirror image corollary after a downside move, strongly suggesting a bottom has been seen (morning star; doji; abandoned baby bottom).
This is a three-candle pattern, with the third day formed by a dark/bearish candle, and typically having ‘closed the gap’ between the first and second candle.
Bearish (top) and bullish (bottom) Island Reversals are major reversal patterns
Candlesticks in Action
Up until now, we’ve shown you a handful of textbook candlestick patterns (courtesy of Candlesticker.com). Now we’ll look at some real-life candlestick patterns that should reinforce your awareness of the importance of candlesticks. The charts we’ll be showing are historical but are from recent history, so no cherry-picking was involved.
We used the Optimus Flow Trading Platform for all illustrations going forward.
Source: Optimus Flow
Bullish Engulfing Line
First up is a recent bullish engulfing line in the ES where the up candle in the oval completely engulfs the body of the previous day’s move down.
A bottom had already been established. Upon breaking out of its lower range, a bearish gravestone Doji appeared. But that move was canceled out by the bullish engulfing pattern that followed the day after, supporting the bullish bias that the breakout had indicated.
Evening Star/Bearish Island Reversal
Source: Optimus Flow
In the Feeder Cattle (GF) chart above, we can see a clear evening star formation at the top-most swing high. This is an extremely strong signal that a top has formed and longs should be covered and possibly shorts entered. At the bottom, we can see a spinning top, suggesting indecision. What followed was a continuation of the downtrend.
Double Doji (with long legs/tails)
Source: Optimus Flow
Next up, a Double Doji appears after the recent advance in the 30-Year T-Bond futures (ZB), but the long tails on the bottom and the small bodies at the top of the range suggest that the move higher is stalling, buyers are losing control, and traders have become more cautious. The indecision marked a turning point in which sellers dominated the next series of movements.
Source: Optimus Flow
A Bullish Hammer?
The chart above of wheat futures (ZW) shows a deep price decline followed by a strong rejection by buyers resulting in an upward close. This is a hammer formation. And often, it can signal a trend reversal, hammering a bottom (however temporary), and a shift from bearish to bullish.
Though we don’t know what the outcome will be (as it hasn’t happened yet), this is an example of the kind of market indications to look for while trading.
Hopefully, by now you have some feel for candlestick analysis, particularly the notion that not every pattern is perfect. Each candle or series of candles can tell a story that may have implications for the trading days ahead.
The best part of candlestick analysis, however, is the speed with which one can analyze them.
Once you acquaint yourself better with candlestick patterns, you’ll be able to discern if there is a pattern or not. Remember, there’s either a pattern and potential signal or there’s not. Be careful not to see patterns that aren’t actually there. As with all trading set-ups, if you miss one, there will always be another one coming along shortly.
- Candlesticks are widely used throughout the trading community and should thus be given great attention;
- It only takes a few minutes to look at a candle chart and identify whether there are tradeable opportunities, or whether it’s best to stay on the sidelines;
- Candlesticks were developed to be used with daily data, meaning the trading signals generated are likely to be longer and more meaningful than short-term analysis;
- Candlestick patterns can be key indicators of a change in market direction (reversal), giving you time to prepare appropriate strategies;
- Candlestick analysis weeds out all the daily market noise and allows you to focus on what the market is doing and what the price is telling you. You’d be surprised at the amount of information contained in a few candles and what they mean going forward.
- On a final note, and to shorten the process altogether, pay especially close attention to small bodies and long tails, as they will alert you to potential upcoming moves.
The Ichimoku System
Developed in the 1960’s by a Japanese financial markets reporter, the Ichimoku System has become an increasingly popular method of technical analysis. We believe it to be one of the most powerful technical trading strategies, and we’re not alone.
Remember when we discussed ‘Why Technical Analysis Works’ earlier. Well, the Ichimoku system is just such an example—it works because enough traders follow it, and more are jumping on the wagon every day, reinforcing the power of the system to produce positive outcomes and avoid excessive drawdowns.
Remember our concept of a three-piece puzzle, allowing traders to gain a comprehensive view of the markets with just three key systems or indicators? The Ichimoku system is the second system and should be easily grasped.
It’s easiest to think of Ichimoku as a modified moving average system, but with a few more parts to it.
The full name of the Ichimoku system is Ichimoku Kinko Hyo, which translates roughly to ‘One Glance Equilibrium Chart,’ but our preference is to call it a ‘One Glance Cloud Chart.’ Either way, the Ichimoku system relies on a series of moving averages with a few tweaks.
The bottom line is that it is a charting mechanism that can reveal a great deal of information with ‘One Glance.’ Both the equilibrium and cloud names reveal the key source of the Ichimoku system: The Cloud or Kumo.
Ichimoku is essentially a trend-following system with 5 key components:
- Leading (Senkou) Span A
- Leading (Senkou) Span B, which together form the cloud (Kumo).
- Tenkan line (faster moving average)
- Kijun line (slower moving average)
- And finally, the Chikou span or Trailing average.
Source: Optimus Flow
Without getting too much into the math, (but feeling that it’s necessary at least), the formulae for the various line are as follows:
The Tenkan Line (fast-moving average): (Highest High + Lowest Low)/2 for the last 9 periods.
The Kijun line (slow moving average): (Highest High + Lowest Low)/2 over the past 26 periods.
Leading span A (forms part of the cloud): (Tenkan-Line + Kijun-Line)/2 time-shifted into the future by 26 periods.
Leading span B (the second element for the cloud): (Highest High + Lowest Low)/2 for the past 52 periods time-shifted into the future by 26 periods.
Chikou span: The Chikou Span is the current closing price time-shifted backwards into the past, by 26 periods.
Ichimoku Parameters: Focus on what the market uses.
You may have noticed that the calculations above rely heavily on the numbers 9,26,52. Why is that? Back when the system was designed, Japanese markets traded on Saturdays as a regular day. As a result, the number 9 stems from 1.5 weeks, while 26 stems from 30 (regular) calendar days minus 4 Sundays=26 or a month, and 52 represents 2 months.
Some Ichimoku users of today have adapted the parameters to 10/22/44, reflecting the number of weekly trading days in the current era. However, in our conversations with Japanese practitioners of Ichimoku, we have found that they prefer the old set of parameters (9,26, and 52).
And since they comprise the majority of Ichimoku analysts, we’ll follow their guidance. Recall once more that it is better to be in the herd by using traditional market parameters than outside the herd with self-designed parameters.
Putting the Ichimoku System to Work
The simplest interpretation (one glance) of the Ichimoku chart is that there is a bullish trend in place when the price is above the cloud. A bearish trend prevails when price is below the cloud. When the price is inside the cloud, it suggests no trend prevails and the market is in ‘equilibrium’. It’s that simple.
But there is more to it. The Tenkan line is the faster of the moving averages and a bullish price move while the price is above the Tenkan line may be expected. The same is true in a down move, where the price is below the Tenkan line, further weakness should be expected. In short, the Tenkan line acts as the first line of support or resistance.
Source: Optimus Flow
The Kijun line is the slower of the two lines (Tenkan and Kijun) and frequently acts as the last line of defense in terms of support and resistance. In an uptrend or downtrend, pullbacks are to be expected.
The Kijun line frequently acts as a critical source of support or resistance in the case of such pullbacks. If you missed the move lower after the Tenkan has fallen below the Kijun line, you may have a chance to sell later on the Kijun line as a source of resistance.
As with any moving average system, crossovers are often critical turning points. The same is true with Ichimoku when the Tenkan line crosses above or below the Kijun line, frequently signaling a change in direction. But the strength of the signal depends on where the crossover takes place relative to the cloud.
If a bullish crossover occurs below the cloud, the crossover higher is of only minimal strength. If the crossover occurs within the cloud, it’s still only a mild signal of a potential upside reversal. Finally, if the bullish crossover takes place above the cloud, it’s a signal of a rejuvenated trend and renewed upside potential. The same rules apply to bearish crossovers.
In the chart above, a bearish Tenkan crossover of the Kijun line took place while below the cloud (upper left corner), suggesting a more significant bearish move lower. Note how price moved lower in line with the Tenkan line, which was recently broken, setting up a move to the Kijun line.
So far, the Kijun line has contained the upside price movement well below the cloud, keeping the trend lower intact.
Source: Optimus Flow
While the Tenkan and Kijun lines are important for medium to short positioning, the cloud remains the key to the entire system. As mentioned earlier, a price above the cloud indicates a bullish trend and vice versa.
The following chart will show the importance of the Tenkan and Kijun lines to the current move higher. Price is well above the cloud at the moment, but the cloud appears to be vulnerable due to its thinness.
When looking at the cloud as a source of support or resistance, keep in mind the thickness of the cloud, as it is directly related to the strength of the cloud as support/resistance. A narrow cloud can easily be breached to the upside or the downside.
But the Ichimoku gives you a heads up due to its extension into the future, where you can visually see whether the cloud is getting larger or continuing to remain thin and vulnerable.
- The cloud acts as a visually simple trend indicator; price above the cloud? uptrend; price below the cloud?
- The thickness of the cloud determines its strength as a point of support or resistance.
- The Tenkan line is the faster of the moving averages and frequently provides the initial level of support/resistance.
- The Kijun line frequently acts as an important support/resistance zone during periods of a pullback; utilizing the Kijun line, you can still get in on the trend, whether up or down.
- Crossovers of the Tenkan/Kijun line may signal a major turning point in the trend
- The Chikou span can be used as an indication of the strength (or weakness) of the trend. If the Chikou span reveals lower prices than the current uptrend, it is considered a bullish signal, and vice versa.
The Average Directional Index (ADX)
In line with our aim of providing only three technical puzzle pieces, the ADX is the final indicator system. It takes only a minute to look at, but can reveal tremendous information for future price action and hopefully prevent costly trading mistakes.
The Average Directional Index (ADX) is the key part of the underlying DMI (Directional Movement Indicator) indicator. We have purposely left out of our discussion the other components of the DMI, namely the DI+ and the DI-, so as to focus on the most important output of the DMI?the ADX. (The DI+ and the DI- are used to calculate the ADX.)
Every trader knows (or should know) the popular trading maxim: “The Trend is your Friend”. Most trends are easy enough to spot through visual inspection or by drawing in good, old-fashioned trendlines (Yes, they still work.).
But what happens when there’s no trend? (Actually, trends are the minority of price movements, while sideways price action constitutes the majority of movements.) That’s where the ADX comes in.
The ADX is a critical indicator of the existence and strength of a trend, as well as a neutral signal when there is no trend.
Just as with most technical indicator systems, we seek confirmation for the signals that we see on a regular basis. The ADX is exactly such a system, showing whether a trend is evident or not. That simple determination can have a material impact on one’s trading success or failure.
Most importantly, getting used to the ADX will build your confidence during periods of trends and being prepared for when they may be changing direction.
What is the ADX?
The Average Directional Indicator (ADX) measures the existence of a trend and its strength. An ADX reading above 25 indicates the presence of a trend, while a reading below 20 indicates non-trending, sideways price action. There are no overbought/oversold signals with the ADX, just the price point at 25, above which signals a trend has taken hold.
It is important to understand that the ADX measures both positive and negative trends equally. For example, if we are confronted by a bearish trend that has lasted for several weeks, which way would we expect the ADX to have moved?
A bit of a trick question, grant you, but the answer is ‘higher’, because the ADX measures both up and down trends. While the prices in a downtrend will continue lower, the ADX will be moving higher as the trend progresses. Also, the higher the ADX moves, the stronger the underlying trend is.
The figure below shows a classic downtrend confirmed by a rising ADX line, above 25.
Source: Optimus Flow
Note the nearly perfect timing of the trend finding a base and the ADX turning down indicating a weakening trend.
It is also important to note that even while the ADX has made a top, it is still in trending territory (>25), meaning the primary down-trend may reassert itself in the days ahead. Only by looking at the ADX compared to the price can help you determine if the market is trending or not.
ADX and Oscillators
Earlier we mentioned avoiding costly mistakes as another reason to note the ADX before making any trading decision. Many traders like to use oscillators (e.g. MACD or stochastics) as the basis for many of their trading decisions.
For example, an overbought slow-stochastic may signal a top for the underlying price, which some traders may take as a signal to exit longs or even enter new short positions.
However, an oscillator can stay overbought/oversold for lengthy periods, leaving traders frustrated and out of the money, while the market trend continues on its merry way.
A quick look at the ADX, however, will reveal if the price is in a trending condition or not.
Remember, even if a price is overbought on the stochastics or RSI, for example, the price can still move higher and stay in an overbought condition for a long time.
If a trader goes short based on the overbought condition, they may soon find themselves in a counter-trend trade that has no end in sight. The figure below illustrates this phenomenon:
As a rule, look to the ADX to get a sense of whether trending conditions are in place, and compare that to the oscillator you’re using.
While the oscillator may be overbought/oversold, knowing what the ADX is doing is critical to trade timing and position entry. Looking at the image above, and following the ADX and the prevailing trend higher, could have yielded several hundred pips (inside purple oval). From the image above, also note that the ADX topped out exactly with the price peak.
Alternatively, when the ADX is below trending levels (i.e.<25), oscillators and other momentum indicators can be relied on to a greater degree in making trading decisions. In a sideways market, it makes sense to utilize oversold/overbought indicators as a trading guide, while in a trending environment the opposite is true.
- The Average Directional Index (ADX) is a measure of whether a market is in a trending condition (>25) or not.
- The ADX is also a measure of trend strength, giving traders a measure of the strength of a trend, regardless of which way the trend is moving.
- The ADX measures both downtrends and uptrends equally (e.g. a downtrend could be seen in a rising ADX, and an uptrend could also be confirmed by a rising ADX.
- When the ADX is in trending territory, users should be very cautious about using oscillators as a trading signal. A market can stay overbought/oversold for longer than you might have capital available. After all, that’s the nature of a trend: successive new lows in a downtrend, and successive new highs in an uptrend.
- When the ADX is below 20, range conditions are present, making oscillators more relevant.
Many traders spend too much time experimenting with various technical indicators, or parameter settings. Our goal is to simplify a trader’s technical analysis down to three key indicators or systems.
Candlesticks are a system on their own; frequently revealing turning points in the market.
The Ichimoku system is widely practiced in Asia and its popularity is moving West. One glance at an Ichimoku chart can reveal which direction a trend is moving, while each of the components (Tenkan, Kijun, Leading Span A, and leading span B) stand out as important points of support and resistance.
The ADX is an excellent indicator of whether the market is trending or prone to sideways price action.
Put them all together and spend 5 minutes looking them over. Odds are good you’ll find a trading signal, whether it’s an entry signal or a sign to exit a position.
That’s it. Just three technical strategies/indicators/systems to apply to markets and seek better potential outcomes and avoid negative results.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.