This is a guest post by Ahmad Hassam
Average Directional Index (ADX) was developed by J. Welles Wilder. ADX was constructed to measure the strength of the trend no matter if it was an uptrend or a downtrend. The idea behind the development of ADX indicator was not to identify a trend but to measure how strong a trend is when it is in place.
ADX is an oscillator that fluctuates between 0 and 100 values. However readings above 60 are rare. Readings below 20 indicate that the trend is weak and a reading above 40 indicates that the trend is strong. The trend can be up or down. ADX does not tell the direction of the trend. It only gives its strength. Direction of the trend can be easily found by just eyeballing the charts or drawing a simple trendline on the chart.
ADX indicator can also be used to identify the potential changes in the market from trending to non trending. For example, when the ADX starts moving from below 20 to above 20, it means that the trading range is ending and the market is developing a trend.
There are many ways to use the ADX indicator in your trading. However, the conventional methods like those described above don’t work in actual trading. The best method to use ADX in your trading is to use it as a filter with your trend trading system.
Suppose you have a good trend trading system. You can use this ADX filter to further improve the performance of that trend trading system. For example, suppose your trend trading system gives a high probability entry signal. Use ADX as a filter. Only take the trade if the ADX is higher than it was the prior day. If ADX is lower than the day before, simply ignore the trading signal generated by your trend trading system.
Logic behind using this ADX filter is simple. If ADX is declining, this means that the market is not trending. So using the ADX Filter, you will ignore the trading signal as the market is not trending.
Only take those trades when ADX is climbing. This will ensure that you only get into trades when the market is already trending. Using ADX as a filter like this will increase the potential size of your winning trade and reduce the number of losing trades as well. However, using ADX as a filter like this will sometimes eliminate a winning trade but you will find that it will eliminate far more losing trades.
Now, when ADX value falls below 40, exit your trade immediately. This is your trend exit strategy. This way you will be able to take profit at or near the end of the trend in many cases with a high percentage.
So whatever trend trading system you are using, you should apply this ADX filter before you make any trade. Try it on the demo account and see how much the performance of your trend trading system will improve.