In an earlier article, I discussed the component parts of the Directional Movement Indicator (DMI) and their uses in e-mini trading. You may want to refer to that article and familiarize yourself with the parts of the indicator. The ADX indicator is by far the most popular segment of the Directional Moving Indicator; so much so that you often see it utilized as a standalone indicator in e-mini trading. I think that is a mistake, and we will discuss the validity of that statement in this article.
Why is the ADX so popular?
For inexplicable reasons, e-mini traders, especially those who trade in the scalping style like me, go to great lengths in defining and identifying a trending market. For swing trading, longer-term trend identification is essential. However, as e-mini scalpers, I am primarily interested in trends (or directional movement in the market) that are shorter-term in nature. As you might suspect, I do not spend an inordinate amount of time identifying trends. In my world, when the price action is moving upwards for an hour or so the market is bullish, and vice versa for a downward trend. I have plowed through texts that and go through elaborate equations and methodologies to identify a trending market. For me, simple observation is adequate.
On the other hand, one thing that you cannot observe is the strength of a trend. There is no finer tool in my trading arsenal than the ADX segment of the Directional Movement Indicator for determining trend strength. Some general guidelines for measuring trend strength using the ADX are:
If the ADX is rising:
· A reading between 15 and 25 = a possible beginning point of a trend
· A reading between 25 and 45 = trend confirmed
· A reading of 45 or more = an overextended market; be vigilant for a potential trend direction change.
If ADX is declining:
· A reading less than 20 = low volatility and chopped market environment; fairly short market swings, use DMI + and DMI- for trade confirmation
· A reading between 20 and 30 = consolidation-type price movement
· A reading between 30 and 45 = correction from an extreme price level is likely.
I feel that I should point out (and you may have surmised) that the ADX is unidirectional. When the ADX is rising, it indicates that a trend is forming or is already in place. If does not indicate what direction the trend is moving. For example, and upward rally looks exactly like a declining breakdown. When e-mini traders first use the Directional Movement Index and see the line moving upward (appearing like a rally, or upward trend) and the market is in a downward trend they are initially confused. After an adjustment period though, most people make the adjustments in thinking to read the ADX.
On the other hand, the DMI + and DMI – are pretty straightforward; they cross just like any other moving average. When they cross, it is a signal to initiate a long or short trade depending upon whether or not the + or – is on top. No worries there, as even beginning e-mini trader are fairly well aware of how moving averages work.
The two components of the Directional Movement Indicator were designed to work in tandem. A long crossover of the moving averages (the DMI + crossing over the DMI – which would put the DMI + on top) with the ADX reading 30 would indicate a potential trade with the trend and would definitely be an indication, a strong indication, of a good trade to the long side. On the other hand, using the same numbers accept the ADX is declining through the 30 would indicate a far less desirable trade and one could assume that the trend is fading.
As you might surmise, J. Welles Wilder was thinking of a complete trading system in the designing the Directional Movement Indicator. While his intentions were certainly good, the indicator is not particularly accurate for individuals who are e-mini scalpers. There tends to be too many crossovers under certain conditions, especially in choppy markets which will have a e-mini trader trading far too often and taking too many trades, many of which are low probability trades. I use the DMI to filter out undesirable trades. When using the DMI as a filter indicator, you are looking at the ADX and DMI moving averages to see if they are, in fact, in agreement in both timing and direction of the trade you are considering.
In summary, we have taken a brief look at the practical application of the Directional Movement Index and its component parts; the ADX, the DMI -, and the DMI +. I have tried to point out some basic readings on the ADX that can increase your chances of a successful trade. I have pointed out that the indicator is not especially effective for e-mini scalpers because it tends to be a bit whippy. Finally we talked some about how the moving averages cross to indicate a potential trade.