Emini Trading Blog

Posts Tagged ‘ADX’

One of the most effective and reliable of the technical indicators for trading e-minis can be the Average Directional Indicator or ADX. Used correctly the ADX can be a stunningly accurate gauge of market trend strength or weakness and coupled with a complementary indicator, can be very effective in setting up trades using the e-minis.

The ADX was created by J. Welles Wilder and introduced in his 1978 book, New Concepts in Technical Trading Systems. Interestingly Wilder, an engineer, is also credited with creating two other well-known technical indicators, the Relative Strength Indicator (RSI) and the Parabolic SAR which are standard indicators in most charting software packages today.

The ADX is made up of three components, the ADX and +DI/-DI. +DI is the positive directional movement indicator while -DI is the negative directional movement indicator. These two indicators are often plotted separately from the ADX to minimize visual clutter. They are designed to indicate the upward or downward (strength/weakness) of trends.

The directional indicators are capable of generating buy and sell signals when they cross. Basically, a buy signal is present when the +DI moves above the -DI and a sell signal is present when the -DI moves above the +DI. However, in volatile market conditions or when issues are in trading ranges, these signals can reverse rapidly resulting in whipsaws. It’s generally accepted that the directional indicators alone are not reliable buy/sell indicators.

The third component of Wilder’s indicator is the ADX. The ADX is an oscillator plotted on a 0-100 scale. The ADX itself is the moving average of the difference between the +DI and the -DI. Readings above 60 are rare, while a reading above 30 indicates a strong trend. Readings below 20 indicate a weak trend or an issue in a trading range. Keep in mind that the ADX is “trend neutral”; its reading can apply to bull or bear trends – the ADX merely indicates the strength of the trend. Generally speaking, when the ADX begins to rise above 20, a trend may be in its early stages. Conversely, when the ADX begins to fall below 40, the current strong trend may be weakening.

Wilder himself in his book advises that the ADX is best used in more volatile market conditions. He also advocates use of what he calls the “extreme point rule” when implementing trades. For use in the E-Mini issues the ADX provides excellent results when used with a complementary indicator such as moving averages. The ADX is also a useful tool for setting up scans for issues in the beginning stages of trends and to avoid issues mired in trading ranges.

Many years ago, early in my trading career, I began to gravitate from the straight support/resistance/volume trading systems and become interested in oscillators and other “exotic” indicators, as they were referred to at the time.  Of course, Welles Wilder’s ‘New Concepts in Technical Trading Systems” was often discussed.  The book was written in 1978.

I had not yet read the book.

So I went to the library to hunt down this book by arguably  the greatest technical analyst of our time.  I was, of course, expecting a large book with lavish charts and difficult to decipher language.  But I was determined to read the book and learn a little about this area of study that Wilder was making wildly popular, much to the chagrin of the old guard and Dow theorists.  Imagine my surprise when the librarian directed me to the book and it was a thinnish sort of thing, not much in the way of writing or explanation, and pretty heavy on mathematic formulae.

But what a book!  And Wilder’s insightful mind and thoughtful mathematic approach to trading is still resonating with traders today.  The book has six individual trading systems that Wilder proposed and briefly explained the rationale behind, which, at first glance, seemed less than impressive to me at the time.  You might recognize several of the names now, because they are just as relevant today as they ever were.

Wilder himself was an engineer, then a real estate broker, and finally found his groove in what then was the fairly new field of technical analysis.   Yes, this thin little book I got at the library contained some of the seminal work in technical analysis because in it, he explained the theory behind his indicators which include the Relative Strength Index (RSI), Directional Movement Indicator (DMI), Average True Range (ATR), Average Directional Index (ADX), and the often misunderstood Parabolic Stop and Reverse.  Many technicians consider these indicators to be the core of current technical analysis.

Thirty years later many traders have continued to use these indicators in their daily work and their popularity continues unabated, and traders have combined and cultivated the use of the indicators in ways Wilder never would have dreamed.  Even more impressive, these indicators are included in every software charting package I have ever used, which is a testament to their enduring popularity and accuracy.   Wilder wrote and imagined these concepts prior to the time of the truly versatile computer, which makes his achievement more impressive than ever.

With the quantification of market movement Wilder exposed the fundamental relationship between price action and the indicators ability to discern the subtle movement in prices.  By implication, he was able to quantify the emotions of fear and greed and the effect they had on price action.  These factors are still not fully understood, but are recognized as prime movers in the daily price action we all observe.

I would be remiss if I did not mention Wilder’s later work, which in my opinion, bordered on either the greatest fraud of all time or sheer lunacy.  He and Jim Sloman developed a theory of market behavior of a distinctly different flavor than his earlier work called the Delta Phenomenon.  Wilder tried, with some success, to convince his admirers that the markets were actually controlled by lunar-solar-earth cycles.  Based upon his past work, many individuals invested $35,000 a piece and he became (at least it is rumored) very wealthy.  There are still several websites proclaiming the Delta Phenomena as a ground breaking theory for investing.  Of course, Mr. Wilder and I would part ways on trading the markets based upon astrological observation.  To many technical traders, the Delta Phenomena dimmed the great intellectual light of Wilder’s work.  The Delta Phenomena is truly some unusual stuff.

Wilder’s early work is the stuff of brilliance, and I would recommend that every trader read the book, then learn the book, as a requisite to understanding modern day trading systems.  Of course, my enthusiasm for his Delta Phenomena is not quite as warm.  However, I feel to get a fair assessment of the man it is important, at least in summary form, to look at the body of work he produced, both good and high debatable.