One of the most important aspects of a trading strategy is having an understanding of the indicators used. Using no more than two indicators on the same chart is also recommended.
To profit on the forex market, you need to build a simple and effective strategy.
The average directional index (ADX) is also known as the average directional movement index. This is one of the common standard indicators on many trading and charting platforms.
Categorized as an oscillator, the ADX is a trend strength indicator. Thus, unlike most other oscillators that measure volatility or momentum, the ADX indicator accounts for when the trend is rising or falling. The ADX can be used in a number of ways, the most obvious of which is trend following.
A trend following strategy, as you might know, is one of the easiest ways to trade. Entering into a trend that is just beginning to strengthen also gives traders the advantage of quickly capturing profits.
This occurs because, when the trend strengthens, the pullbacks are minimal, thus ensuring that, with the right take profit levels, day traders can capitalize on such price movements.
Trading strategy using the Average Directional Index
The average directional index belongs to the class of oscillator. Thus, the indicator is found in the sub-window. The ADX indicator consists of three components.
The first is the ADX line. This line is used to signal the strengthening and weakening of the trend. The ADX line oscillates around the level of 25. When the ADX line rises above 25, the strength is said be strong, and when the ADX line is below 25, the trend is said to be weakening.
Note an ADX above 25 in a bearish trend suggests a strong bearish trend, and an ADX above 25 in a bullish trend suggests a strong bullish trend.
The remaining two variables in the ADX indicator are the +DI and -DI lines. These lines visually depict the bullish and bearish trends. Similar to a moving average, the +DI and -DI lines tend to crossover or intersect.
Thus, determining how the +DI and -DI cross over and finding the value of the ADX line will give you the full picture.
The ADX indicator tells you when the trend is bullish or bearish and if this trend is strong (based on the ADX value at or above 25) or will weaken.
ADX strategy rules
The trading rules with the ADX indicator are very simple. The first step is to use this indicator on the H1 chart because our trading strategy focuses on intraday trading only. Therefore, add the ADX indicator to the H1 chart and make sure to have the session dividers enabled on your MT4.
Once this is done, you can plot yesterday's high and low levels. The chart below gives a basic overview of how your chart would look when you add the ADX indicator to the H1 chart and plot yesterday's high and low levels (The shortcut key is Ctrl+Y).
ADX set up with yesterday’s high and low
Long positions are taken when the price breaks the previous day’s high. When this is breached, look to the ADX indicator to determine your trend. Firstly, the +DI must crossover above -DI. This indicates the trend is turning bullish.
The next step is to look for the ADX indicator rising above the 25 level.
The above chart shows the price breaks out from the previous day’s high and the +DI was greater than (or crossed over) the -DI line, suggesting the bullish trend. You can also see the ADX line started to rise, and at the time of the breakout from the previous day’s high, the ADX was above 25.
Stops can be set to the most recent pivot low, and the take profit level can be set to 1:2 or you can simply close the trade by the end of day.
For short positions, first start by plotting the previous high and low. Then, look to the ADX indicator. The -DI and +DI must signal a bearish trend. This means the -DI must crossover above the +DI, suggesting the trend is bearish.
Finally, wait for the price to break the previous day’s low, and then, with the ADX indicator above 25, you can take a short position.
The above chart shows a short position example using the previous day’s high/low and the ADX indicator. Here, the price breaks the previous day’s low. The -DI is higher than the +DI cross over. This suggests a bearish trend in price action.
Finally, the ADX line is clearly above the 25 level, suggesting the bearish trend is strong. As a result, short positions are taken here. The stops are placed at the recent pivot high. The targets can be set to 1:2 at the very least or the position can be closed by end of day.
Comments by traders
Many traders falsely believe that the more indicators they use, the more robust their trading strategy will be. However, contrary to this opinion, you must know what the indicators are signalling. If you just add more indicators on the chart, and hope for the Holy Grail strategy, soon you will be lost.
The ADX-based trading strategy is a simple intraday system, it is ideally used by day traders. Because we combine the concept of the previous day’s high and low and then take the position of the breakout from these levels using the ADX indicator, traders can rest assured they are entering into a position when the trend is starting to become strong.
The ADX-based trading strategy, as a result, can be used effectively and can be applied to any currency pair. With the stops relatively tight and the profits usually higher than the risks, the strategy could be profitable in the long term.