Using Average Directional Index - A useful addition to your toolbox

Many traders concentrate on the popular momentum indicators looking for overbought and oversold signals and possibly even price/momentum divergence at the end of a trending move.

Let us just look at how Rapid RSI performs in identifying overbought and oversold signals in the daily chart for the US Dollar vs Japanese Yen:

Very clearly it has been very successful and if this is your first experience of using momentum indicators you may start imagining buying your first yacht! However, as with just about any technique in technical analysis it is never quite that simple. Let us take a look at a different section of price action:

Quite clearly while the first two signals (first a sell signal followed by a buy) were very successful.

However, following this Rapid RSI issued constant sell signals but price continued directly higher.

What has happened?

Very simply, momentum indicators will provide good overbought/oversold indications within a consolidating and freely swinging market. However, this breaks down when the market begins to trend - and this is what happens in USDJPY.

During a trend momentum indicators will spend most of the time oscillating around the overbought or oversold extreme and will never provide a signal in the direction of the trend. At these times we need to ignore momentum signals. What we need to try and organize is a method of recognizing when price begins to trend. This can be managed by using another Welles Wilder indicator, Average Directional Index - or ADX.

Let us apply this on the same chart.

On this chart I have added in ADX (in green) along with +DI and -DI in blue and red respectively.

+DI and -DI display the individual positive and negative movement seen and when price direction is higher it can be seen that the +DI line crosses above the -DI line and vice versa.

ADX is the Average Directional Movement of both positive and negative moves. It can be seen that when price moves consistently in one direction (ie there is a trend - this may be an uptrend or downtrend) ADX rises above the 30 line to indicate that a trend is under development.

I have marked on the chart when this occurs approximately. Then, while ADX is rising above 30 it is possible to ignore the RSI signals.

However, ADX is a lagging indicator by definition and there will always be a period before it moves above the 25-30 area when the momentum indicator moves into the overbought or oversold area. How can we manage that situation?

Well first of all, just because the momentum indicator has moved into the extreme area, it is not an automatic trading opportunity. In this case, when Rapid RSI moves into overbought territory we should be examining price action in not only the daily chart as shown, but also the intraday market.

In this case I have taken the lead-up to the point until ADX crosses above the 25-30 area. What is very evident is that it is following the very basis of a trend - that is swing highs and moving higher as well as swing lows moving higher.

The picture above shows an uptrend where both peaks and troughs are rising and when one of the troughs is broken then we are on warning that a reversal in trend is possible.

In the case of the USDJPY daily chart it is quite clear from the inset that we never saw break of one trough and therefore we should be staying with the move higher even though ADX hasn't yet registered this mathematically as a trend.

We have been able to draw a supporting trend line across several troughs and when this breaks we can say that the trend is probably complete. There is a small risk of moving back to retest the trend line after breach and this does occasionally occur at new high, but given that ADX has already begun to decline we can more safely assume the uptrend is complete and can look for Rapid RSI to provide overbought and oversold signals.

So look to add ADX into the list of indicators you use to provide an objective view of when a trend is in place. It is a good addition to your tool box, adding information instead of duplicating with yet another momentum indicator.

At less obvious time you can refer to Pro Commentary for information on projected targets and yet another objective view on the market.