Crypto Academy / Season 3 / Week 7 - Homework Post for [@kouba]. Trading Crypto With Average Directional Index (ADX) Indicator

Hello Professor @kouba. Researching further about this indicator I can realize that it is actually a very well known indicator, but almost nobody knows how or why it works. For this reason I find this class wonderful.

Let's start

0_{Image edited by me in Powerpoint}

Intro

One of the most important elements in the trading world is trending, however detecting and measuring trends is not easy; in fact, the market is rarely trending.

The interest in trends is obvious, as it is like riding a wave and expecting it to take us to the promised land. But what is a trend...or how do we measure them...and more importantly, when do we know there is going to be one?

With this in mind, Welles Wilder tried to solve this problem by creating an indicator that would objectively tell us when there was or was not a trend. This is when the ADX indicator was born.

1. Discuss your understanding of the ADX indicator and how it is calculated? Give an example of a calculation. (Screenshot required)?

ADX in a nutshell, is a technical indicator that measures price trend intensity, although, in reality, ADX is a mix of indicators that through their interaction will give us an objective measure of the price and the intensity of its trend.

Graphically, the ADX is composed of three lines, the first one (red) which is the ADX line itself, and two others called DI+ (blue) and -DI (orange).

_{UNI/USDT, 4h chart. Image edited by me and taken from Tradingview: ^Source}

The function of the ADX line is to indicate the strength of the trend (regardless of direction) moving in a range between 0-100, which represent:

-0 to 25: No trend.
-25 to 50: Existence of a trend.
-50 to 75: Very strong trend not very common over long periods of time.
-75 to 100: Extremely volatile trend. Very strange and very uncommon.

On the other hand, the function of the DI+ and DI- line is to indicate the direction of the trend, as well as to reaffirm the strength of the trend. So we have these two cases:

-If DI+ is above DI- the trend is Bullish.
-If DI- is above DI+ the trend is Bearish.

For both cases, the farther the two lines are from each other, the stronger the current trend. If on the other hand the lines move closer together this indicates loss of strength.

Calculation

Let's start from the beginning. To construct the ADX Wilder first had to decide how to measure directionality. So he finally came to the conclusion that a market has a bullish directionality (for example) when the next candle has the high above the previous high and that difference between the new high and the previous high he calls DM+.

If on the other hand, we have a low below the previous low we consider that there is bearish directionality and the difference we call it DM-.

Their formulas are these:

-DM+ = current high - previous high
-DM- = previous low – current low

And graphically it looks like this:

_{Image edited by me in Powerpoint}

From these values, an indicator itself is constructed which is called DMI (Directional movement index) which consists of the two lines DI+ and DI- that I mentioned previously. One of them measures bullish directionality and the other measures bearish directionality.

These lines are constructed by taking the DM+ and DM- of the last 14 periods (the original number of periods chosen by its creator) and dividing it by the TR (True Range) of the same period.

The TR formula is, The maximum value of:

-Current high - current low
-Current high - previous close
-Current low - previous close

However, in order to calculate the DI+ and DI-, a smoothing of DM+, DM- and TR must be done first, based on the 14 established periods and through a very complex procedure of exponential moving average calculation. These are the formulas.

_{Image edited by me in Powerpoint}

Then, the calculation of DI+ and DI- is through these formulas:

_{Image edited by me in Powerpoint}

Finally:

DX= ABS[(DI+) – (DI-)] / [(DI+) + (DI-)]

And, then a 14 period smoothing is applied again on DX resulting in:

ADX= Sum of 14 [((DI +) - (DI-)) / ((DI +) + (DI-))] / 14

Example

Assume the following value data between two bullish candlesticks.

DATA	VALUE
current high	0.6
previous high	0.48
previous low	0.40
current low	0.46
previous close	0.45

First we calculate DM+ and DM-.

DM+ = 0.6 – 0.48 =0.12
DM- = 0.40 – 0.46=-0.06

Then, to calculate TR, we perform the three operations:

0.6 – 0.46=0.14
0.6 – 0.45=0.15
0.46 – 0.45=0.01

We select the highest value TR=0.15

Due to the complexity, I will skip the smoothing operation directly to the calculation of DI+ and DI- with the values of DM+, DM-, and TR.

DI+ = 0.12 / 0.15 =0.8
DI- = -0.06 / 0.15=-0.4

Finally:

DX= ABS[(0.8) – (-0.4)] / [(0.8) + (-0.4)]

DX= ABS[1.2] / [0.4]

DX=3

Naturally, this is only one value of several that must then be applied in the ADX Exponential Moving Average formula.

2. How to add ADX, DI+ and DI- indicators to the chart, what are its best settings? And why? (Screenshot required) ?

1-Click on the top button of indicators and strategies.

2-Then a pop-up window will appear with the list of indicators. Type DMI and then select Directional Movement Index.

_{Image edited by me and taken from Tradingview: ^Source}

3-After selecting it, we close the pop-up window and the indicator will appear on screen with the ADX, DI+, and DI- lines. To configure it we must click on the settings button.

4-A new inputs window will appear. There we configure the values of the indicator, although the standard value of 14 will appear by default. Finally, we click ok to finish.

_{Image edited by me and taken from Tradingview: ^Source}

Finally, the last question has a catch... since, in reality, the ADX is an indicator ADAPTABLE to any trading style, so there are not better settings than another.

Actually, the 14 period setting was chosen by its creator because it is a mid-range that he used in other of his indicators. But we could simply work with 7, 9, and 30 settings.

We must be careful at what point we are going to use those values. For example, the 7 and 9 period setting is very sensitive and is perfect for use in some swing trading, however, if used in another type of trading such as scalping it can show many false signals.

On the other hand, a 30 setting is perfect for scalping as it is less sensitive, smoothed, and will show more accurate not volatile values. However, if it is used for swing trading for example... we will find that the indicator will give very late signals.

3. Do you need to add DI+ and DI- indicators to be able to trade with ADX? How can we take advantage of this indicator? (Screenshot required) ?

Not really. The ADX indicator can do its job on its own.

I think the decision to use the ADX alone or accompanied is just a matter of taste. Let's remember that the ADX is made just to show the strength of the trend, the DI+, and DI- complement that function.

In fact, if we think about it, the ADX could work very well only if we use it in conjunction with an indicator like RSI, MACD, or Ichimoku.

Because in this way the MACD, for example, would show entry points and the ADX would confirm the validity of that entry by the strength of the trend.

_{Image edited by me and taken from Tradingview: ^Source}

If we look at the chart we can see two cases where MACD gives a buy signal, however only one is a Good entry, the other is a bad point. How do we know which one is the good one and which one is not? Here enters the ADX which is telling us that one signal is in a strong trend zone (ADX=40) while the other is in a weak or non-existent trend zone (ADX=22).

On the other hand, the only drawback is that the ADX alone does not tell us the direction of the trend. This is where we can also use the DI+ and DI-.

_{Image edited by me and taken from Tradingview: ^Source}

This time we add the DMI indicator containing the ADX and DI+ and DI-. Again the moment the MACD gives us a signal, the ADX indicates a strong trend which is confirmed by the DI+ and DI- as an uptrend.

With this example we can see the benefit of using ADX in conjunction to DI+ and DI-, as we can also know the direction of the trend. In addition, the separation between DI+ and DI- works as a strength indicator just like ADX.

4. What are the different trends detected using the ADX? And how do you filter out the false signals? (Screenshot required) ?

1-Weak or non-existent trend.

In this trend, the ADX is in a range between 0 and 25. This occurs just at the moments where the price experiences sideways movement or consolidation. In other words, there is no marked downtrend or uptrend.

_{Image edited by me and taken from Tradingview: ^Source}

2-Strong Trend

In this trend, the ADX is in a range between 25 and 50. At this point, the price begins to show a strong start of a trend.

_{Image edited by me and taken from Tradingview: ^Source}

3-Very strong trend

This trend is very rare and occurs for short periods of time when the price undergoes very sharp and rapid upward or downward movements. The ADX is in a range between 50 and 75.

_{Image edited by me and taken from Tradingview: ^Source}

4-Extremely volatile trend

This case is even stranger, it occurs when the price experiences out-of-the-ordinary volatile behavior, which is almost always the result of external news that affects the market. In this case, the ADX is between 75 and 100.

_{Image edited by me and taken from Tradingview: ^Source}

The only case I found was DOGE's sudden rise due to Elon Musk's tweets in April. The ADX was positioned for an instant at 76.

How do you filter out the false signals?

The way we can filter out false signals is through observation of the ADX line with respect to the price action. For example:

_{Image edited by me and taken from Tradingview: ^Source}

In this first chart, we see how the ADX normally behaves, rising when the trend gains strength and falling when the trend reverses due to a loss of strength.

On the other hand, we must be attentive when one of the most common false signals occurs, a Divergence. This occurs when the ADX goes down, showing a loss of strength, yet the price still remains in the main trend. For example:

_{Image edited by me and taken from Tradingview: ^Source}

Finally, what we are looking for from a clean signal is that ADX accompanies price action. As the price trend is increasing, the ADX should make higher and higher peaks, in confirmation of the strength of the trend. For example:

_{Image edited by me and taken from Tradingview: ^Source}

As the uptrend develops, we see the ADX making higher and higher peaks. This is confirmation of the strength of the trend.

5. Explain what a breakout is. And How do you use the ADX filter to determine a valid breakout? (Screenshot required) ?

A breakout is an event that occurs when the price of an asset that for a long time was in consolidation (Range) suddenly breaks structure and shows signs of initiating a new uptrend or downtrend.

However these breakouts are deceptive, and usually, after showing the start of a new trend, they suddenly return to the consolidation movement, thus leaving traders in a very bad position. It has happened to me several times

However, through the ADX we have a valuable tool to detect these false breakouts, by means of the position of the ADX line with respect to the 25 lines.

_{Image edited by me and taken from Tradingview: ^Source}

In this first case, we see that the price was in a prolonged period of sideways movement (Range), at the same time the ADX is below the line of 25. Later, at the same time that the price breaks the consolidation structure, the ADX also breaks the line of 25. This is a confirmation of a valid Breakout in which later it can be observed that the price forms a prolonged uptrend.

On the other hand, we can see an example of a False Breakout.

_{Image edited by me and taken from Tradingview: ^Source}

As we can see, after a period of consolidation, the price breaks the structure, but ADX remains below the level of 25. This means one thing: Invalid Breakout. What happens then is that the price goes back down and enters a sideways movement again, giving the ADX the reason.

6. What is the difference between using the ADX indicator for scalping and for swing trading? What do you prefer between them? And why? ?

The difference lies in the function that must be fulfilled for each type of trading, since for each trading style, both the temporality and the setting must be configured in a special way and adapted as required.

For Scalping

As we know these trades are very short and look for quick profits in low time frames of 1 to 5 minutes. These time frames experience a lot of volatility, so it is recommended to set the ADX to 30 periods or more to counteract the volatility. p>

_{Image edited by me and taken from Tradingview: ^Source}

In this chart, we see a 1-minute Scalping trade, with a 30 period ADX, which smoothes the line and makes it less prone to react.

For Swing trading

On the other hand, for Swing trading what we are looking for are long-term investments and operations, with high timeframes, preferably at 1D. For this reason, to maximize the possibility of entries you can set the ADX to 9 or 7, this way the indicator is more sensitive and can detect movements more quickly. Otherwise, some trend movements may be overlooked.

_{Image edited by me and taken from Tradingview: ^Source}

What do I prefer?

I think at this point in my career I prefer Scalping using a 30 period ADX.

The reason is simple, it goes hand in hand with my financial goals and is in line with my personality.

I have nothing against swing trading, in fact, until a few months ago I preferred it, so what made me change my mind?

Through scalping, I can set small short-term goals that motivate me every day to achieve them. I feel that even if the profits are few, I keep myself active and moving forward, consolidating my experience and my experiences. Every day I advance one step at a time.

In other words, I see more action more often. Otherwise with swing trading I only see action or movement in very long or spaced periods of time.

Conclusion

In summary, the function of the ADX is to try to objectively measure the strength of trends, and in this way, it can be of help to traders. However, like all indicators, it should never be used in isolation but is always best used with price action and in conjunction with other indicators.

An important point to remember is that the indicator is only supporting but does not decide the context. First of all, we are the ones who should always define how to use the indicator so that we can set the timing and smoothing correctly.

Finally, a personal recommendation is that we should pay close attention to the highs of the ADX, in order to be sure of the reliability of the trend and also to try to anticipate consolidations, because when divergences occur we are indicating that the trend is losing strength and perhaps a period of sideways movement begins. If we think about it, this can help us to think about making an entry or an exit in our operation.