ADX with Alerts Template

Introduction

Examples

DMI

ADX

Further Exploration

Download

INTRODUCTION

My favorite market technician, second only to Richard Wyckoff, is Welles Wilder. His contributions include RSI, PSAR (Parabolic Stop & Reverse), Average True Range (ATR), the Accumulation Swing Index (ASI), the "Delta Phenomenon" (of which PVAC is a form), and the Directional Movement Index group (+DMI, -DMI, and ADX), the subject of this article. For further reading, here is a very nice article on Wilder's work.

Wilder discusses the mechanics and formulation of the DMI in his book New Concepts in Technical Trading Systems, where he observes that the market trends only 30% of the time. Most day traders can attest to the havoc chop can wreak. Using a method that seeks to identify not just the trend areas, but the non-trending areas can be crucial. When not trending, with a reliable confirmation of such, a trader can elect to simply stand aside and prepare for the trending phase. It will mean prolonged periods of "doing nothing", but as Jesse Livermore once said,

"It never was my thinking that made the big money for me. It always was my sitting tight."

One can sit tight not only on a winning trade, but also sit tight by standing aside through chop. ADX seeks to show when to stay with a trend and when to step aside and wait for congestion to resolve itself.

In a nutshell, the indicator is based on True Range and exploits the idea that true range compresses during congestion/chop and expands when trending. For more details, Ensign users can also click the "Help" button on the DMI Study Pane for a short explanation.

My template incorporates several of Wilder's key ideas and generates conditional Buy and Sell signals based on the +DMI/-DMI cross. The template and short explanation may be downloaded by Ensign users.

EXAMPLES (click to show full size in a separate window)

Shown below is an example of ADX with Alerts, Version 1.

(The background is an Alan Box based on last month's data.)

Here is the Minimalist version with "Chopzilla" Band

I use a period of 9 as my default but this may be changed by the user. A typical value is 14.

I include an Auto Trend indicator, shown against this background color very lightly so as not to pull the eye too much from price. It isn't used, however, by any of the template elements.

There are no DYOS or Global Variables used in this template.

General Comments

Wilder's Approach: Use the +/- DMI crosses for entries; Stay out completely when ADX is below 20.

John Murphy's approach: A rising ADX line favors moving averages; a falling ADX favors oscillators.

DMI- Directional Movement Index

There are two DMI: +DMI, which indicates positive price trends and -DMI indicating negative price trends. When +DMI is above -DMI, keep a Long bias and when -DMI is above +DMI, keep a short bias.

The original Welles Wilder approach was designed as a SAR (Stop and Reverse) method where you use the reverse point -- the Extreme Point high or low following the Signal Bar-- as your market entry or exit price even if the +DI and the -DI remain crossed for several trading intervals. This is to reduce whipsaw. I myself haven't back-tested this part of the method.

When I first encountered DMI, the jagged red and blue DMI lines were very confusing to me, just more information than I needed. So, rather than plot the DMI, I have chosen to plot a histogram of the spread of the +DMI/-DMI. I then have only two things to compute visually: Blue histogram is Long bias and Red Histogram is Short bias. A rising histogram indicates greater spread, which preserves that particular beneficial aspect of the "line" display.

Welles Wilder considers the cross of the +/- DMI to be the key signal. The shift of the histogram across the midpoint, from Blue to Red (or from Red to Blue), indicates such a cross.

These DMI-cross signal alerts are marked on the price chart with a B (Buy) or an S (Sell). Additionally, a line is placed at what Wilder calls the bar's "Extreme Point". The Extreme Point is the signal bar's High for a Buy and the signal bar's low for a Sell.

Thus, the trader must watch the bar following the signal bar and only if it closes outside of the "Extreme Point" is the signal taken. If the next price bar fails to go above (or below) the Extreme Point, the signal is discarded. Treat an inside bar as a continuation of the signal.

ADX - Average Directional Index

Rather than mark the raw ADX with zone colors, I've plotted various averages of ADX as White/Black lines in the sub-window. ADX "reversals" aren't in themselves signals, but rather signs that the trend is weakening. White upward lines indicate the trend is gaining strength and black downward lines indicate it is weakening.

Wilder considers ADX over 25 (or 30) to be a trending market. The template marks zones where ADX is *below* 25 with an Orange background to show "non-trending".

The longer ADX remains below 20, the greater the odds of a strong trend once ADX begins its climb up. Consider the adage that a period of low volatility is often followed by a period of high or even explosive volatility.

I do use raw ADX in marking trending/non-trending indications in the sub-window midpoint (50% grid) where I overlay three sets of "trend/non-trend" markers:

The innermost Bands are as follows: Solid White Band is ADX>30; Solid Black Band is ADX<20; the transition zone between 20 and 30 is a Solid Yellow Band.

Wilder says that when ADX is above both +DMI and -DMI, this is a sign of a trending market. This is marked with small cyan dots. When ADX is below both +DMI and -DMI, Wilder advises not using any trending method, ie, stand aside. The dots are orange when ADX is below the two DMI.

I "tweaked" this particularly valuable indication to be more prominent and it is now incorporated in the v1 template above as a wide light orange band (rather than small dots), when ADX is NOT above the DMI. .

Finally, a rising ADX indicates a strengthening trend and a falling ADX indicates a waning trend. This is shown on the 50% grid as white (rising) and black (falling) dots.

Note: The sub-window 50% grid "finessing indications" are best used as "quick glance", where the light colors indicate trending and the dark/warning colors indicate non-trending. If you are in a higher timeframe, of course, you have time to study the nuances if you find them useful.

FURTHER EXPLORING

Because DMI and ADX are used to filter chop, it can be used as a complement to other trend following methods. John Murphy suggests using DMI with PSAR method: "When the +DI line is above the -DI line, all Parabolic sell signals can be ignored", and vice-versa.

Linda Raschke uses a 14-period ADX with similar filtering, ie, consider that price is trending when ADX is above 30. In addition, when ADX has been high and reverses, odds are 80% for a retrace. She looks for price to retrace to at least the 20ema. When ADX is below 20, Wilder's "non-trending" zone, Raschke uses oscillators, which are also uses if ADX is below 30 and declining.

Here is an interesting approach using Volume and ADX breakout.

Good trading!

DOWNLOAD (right click and save in an Ensign Template folder)

Minimalist version. Shows chart signals and Chopzilla Band
Version2: 20 Feb 06

ADX with Alerts_v2.dat
ADX with Alerts_v2.doc

Removes all indicator lines and replaces it with a "Chopzilla Band" that is
-- White when price is likely trending
-- Red when ADX<20 (Wilder's "Do Not Trade" zone)
-- Orange Hash when ADX<DMI values

The later is trader discretionary. There is an idea that when ADX is above both DMI, higher quality signals are produced. Meaning that when ADX is below the DMIs, lower quality signals result, thus the orange hash lines. I have not validated this myself, but include it as it makes intuitive sense.

Loaded version: Shows all Indicator lines and best signals
Version1: 20 Feb 06

ADX with Alerts_v1.dat
ADX with Alerts_v1.doc

Normalizes the sub-window to a 0-100 scale.

Adds a pale orange band when ADX is below the DMI values

*Does not* show Buy and Sell signals when ADX is below 20.

Adds near-background colored DMI value displays

Hint1: I use a tan background, so the "light" colors of the Auto Trend and added DMI lines may not display nicely on black or white or other colored backgrounds. Both of these studies are at the top of the objects list and may be changed as needed to better match your color scheme.

Hint2: If you prefer the sub-window data expanded, on the topmost Directional Movement Index study, unclick the box labeled "Plot 0..100"

Initial version: Shows all signals and most indicator lines
Baseline Version: 18 Feb

ADX with Alerts.dat (template)
ADX with Alerts.doc (short explanation)

Here is a link to a chart of the
Baseline version of ADX with Alerts.

[ by the way, you can buy a Tradestation version of Wilders DMI system for $199.95 at Jan Arps ;) ]