Detecting a strong directional move is the most important skill for all traders to have. Trend chasing is the most popular technical method of profitable trading. But stock prices spend more time in consolidation and less time in trending move and so trend trading are prone to frequent draw-downs. So before employing trend trading it is important to know whether the stock is in a trend or not.
The Average Directional Index (ADX), Minus Directional Movement Indicator (-DMI) and Plus Directional Movement Indicator (+DMI) represent a group of directional movement indicators that form a trading system developed by Welles Wilder called the Directional Movement System. The following is a fairly straightforward and one of the most popular trading strategy using the ADX indicator values to confirm a strong trend with crossovers of +DMI and -DMI to generate buy/sell signals.
Average Directional Index (ADX)
The Plus Directional Movement Indicator (+DMI) and Minus Directional Movement Indicator (-DMI) are derived from smoothed averages of high-price and low-price differences and measure trend direction over time. The Average Directional Index (ADX) is in turn derived from the smoothed averages of the difference between +DMI and -DMI. It measures the strength of the trend (regardless of direction) over time. The greater the width between +DMI and -DMI, the higher is the ADX value, the stronger is the trend.
Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when ADX is below 20. The following range of values of ADX can be used for reference:
The Average Directional Index (ADX) is used to measure the strength or weakness of a trend, not the actual direction. A common misconception is that a falling ADX line means the trend is reversing. A falling ADX line only means that the trend strength is weakening, but it usually does not mean the trend is reversing. Directional movement is defined by +DMI and -DMI. In general, the bulls have the edge when +DMI is greater than -DMI, while the bears have the edge when -DMI is greater. Crosses of these directional indicators can be combined with ADX for a complete trading system.
We’ll be using ADX values above 25 to confirm a strong trending market. This is common for both bullish and bearish scenarios because whether uptrend or downtrend, we only want to enter trades when the trend is strong. The +DMI and -DMI lines meanwhile interact with each other to confirm whether that trend is up or down. When the +DMI line rises above the -DMI line, the trend direction is said to be up. When the +DMI line falls below the -DMI line, the trend direction is said to be down.
- A strong trending market is confirmed when the ADX value is greater than 25.
- Once a strong trend is confirmed, we’ll generate a buy signal when +DMI crosses above -DMI which is the condition for an upcoming uptrend.
- Again, a strong trending market is confirmed when the ADX value is greater than 25.
- Once a strong trend is confirmed, we’ll generate a sell signal when +DMI crosses below -DMI which is the condition for an upcoming downtrend
Building on Mudrex
ADX trading requires a lot of self-discipline. This is because you have to wait for the best trade signals. The Mudrex platform helps traders automate their trading and hence helps you execute your trading without the need to maintain this discipline!
As discussed above, lets first write our entry/exit conditions so that we know what to do:
- ADX > 25
- +DMI crosses up -DMI
- ADX > 25
- +DMI crosses down -DMI
Note: We won’t use Stop Loss or Take Profit so that we don’t miss out on up or down trends preceded by a consolidated price which might generate a false Stop Loss or Take Profit signal due to which we can lose the upcoming opportunity of buying/selling using the above strategy.
To make the first buy condition on Mudrex, we’ll use the ‘indicator’ block to make sure ADX value is greater than 25:
To make the second buy condition, we’ll use a ‘compare’ block to generate a buy signal when +DMI crosses up -DMI:
Joining these two using an ‘AND’ block to generate a buy signal:
Similarly, a sell signal when ADX>25 and +DMI crosses down -DMI can be constructed. The overall strategy looks somewhat like this:
This is how easy it is to build your own profit-generating strategies on Mudrex within minutes!
We can now run a quick back-test to see how our strategy performs. Since the past 3 months has been one hell of ride for the Bitcoin market with the CoViD-19 situation and Bitcoin Halving around, running one over the past 3 trending months using a tick cycle of 12H gives us pretty convincing results with a Sharpe Ratio of 2.01 and a Profit Factor of 7.62!
The Directional Movement System indicator calculations are complex, interpretation is straightforward, and successful implementation takes practice. +DMI and -DMI crossovers are quite frequent and chartists need to filter these signals with complementary analysis. Setting an ADX requirement will reduce signals, but this uber-smoothed indicator tends to filter as many good signals as bad.
By applying the ADX indicator trading rules one can take advantage of the strength of the trend and cash in quick profits. The bottom line is that the best profits come from catching strong trends and the best ADX strategy can help you accomplish your trading goals.
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