While it’s true that you don’t need anything other than your own eyes in order to identify whether a market is trending or not, many traders still feel more comfortable using some basic technical indicators to assist with the task.
In a previous article, we had discussed the importance of understanding the exact significance of any visual aid you place on your charts. Today we will explore a familiar indicator (ATR) and a new entry (ADX), and perhaps illustrate some core trading concepts with these indicators.
In particular, we will see that volatility (measured with the ATR) can be a strong indicator of market direction, whereas ADX is a good measure of trend strength (but not in the way you think).
Find the Trend with ATR
I personally find it impossible to trade without a very clear indication of where the asset in question is going. I need to know whether the bias is up, down, or just choppy. Unfortunately moving averages and other indicators really never worked for me, because I wanted something more ingrained in market structure or market behaviour.
This is where the concept of “momentum” comes into play, and here’s why: market participants are constantly absorbing and digesting the flow of fundamental data and local dynamics from the various regional economies. Most of the time, participants are able to react in time, and the prices we see on our charts remain rather “dull”. This is when trading becomes “technical”, because markets have reached some form of “temporary fair value” and are rangebound or just moving without any determination.
However, when the market receives a shock, or dynamics change and participants need to radically alter their positions, then you have strong movements. This is what happened in the recent past with the Sterling. A combination of events radically shifted the market’s perception of the Pound, and we witnessed a move that was roughly 4 times the size of normal trading days.
These boosts in momentum are significant, because they usually mean the market has been pushed out of balance and needs to now find a new balance, given the information that caused the shock. Up to a certain point, the fundamental reasons for the shock may elude us. We might be able to understand part of the story, but we will never really understand the whole story.
What we can do, instead, is measure the impact of the shock and attempt to follow the move for as long as it will go. This is where ATR comes in handy. ATR measures the amount of space an asset usually moves over a given time frame. In order to capture these price shocks, let’s arbitrarily say that any move larger than 2*20-Day ATR is significant. But 2 ATRs from what? We need a starting point that gives us information about where we are potentially going.
In the chart above, we have “UPTREND” levels and “DOWNTREND” levels. These levels are purely dictated by volatility (ATR) and price, as such:
- UPTREND Level = Close (T-10) + 2*20Day ATR
- DOWNTREND Level = Close (T-10) – 2*20Day ATR
As you can see, this simple rule has kept traders facing the right way ever since the “shock” on April 18th. GBPUSD maintained strong momentum for 2 weeks, and only in the current week is reverting to “technical” trading conditions, even though we may even confirm another move higher today if we close above 1.2965.
This rudimental chart compares the Daily close for GBPUSD since 1/1/2017 until today (5/5/2017), with the ATR UPTREND/DOWNTREND signal line (Orange). The ATR signals an UPTREND when it goes to 1. When it falls to 0, the trend is still up but it is deemed “choppy”. When the ATR signal goes to -1, is signals a DOWNTREND.
In the chart above, the green line is the UP threshold and the red line is the DOWN threshold. The key benefit of using this simple volatility rule for identifying the trend, is that the “threshold” levels can be identified ex-ante. For example:
- tomorrow’s UP level = Close (T-9)+ 2*today’s 20Day ATR.
and if we assume the same level of volatility will be maintained or the coming days, we can push the calculation further out:
- day after tomorrow’s UP level = Close (T-8) + 2*today’s 20Day ATR.
Of course using a 10-Day lookback, and using 2*20Day ATR is just an example. The key is to logically think about what you’re looking at. ATR measures movement. How much movement do YOU want to see, before it’s significant? And what lookback period do you want to refer to? Work with the numbers, learn how they react, and create something YOU can totally trust.
How to filter trend strength with the ADX
The Average Directional Index (ADX) was created by Welles Wilder in the 1970s because he noticed that most profitable trading systems were trend-trading systems but these systems tended to:
- have very low hit rates (because the market isn’t normally in a strong trend)
- work best in volatile trend environments
- give back lots of profit because of the lagging trailing stops utilized
A page taken from Welles Wilder’s book “New Concepts in Technical Trading Systems – 1978”. When you wonder how many old-school traders discovered what they know, picture long days charting by hand, observing the markets and uncovering implicit market dynamics.
So Welles created the ADX to assist trend traders because it measures trend strength without regard to trend direction. You can view this spreadsheet to understand the calculations and do simulations for yourself. But for now the important thing is to know that Wilder utilized simple daily highs & lows to identify market strength.
In the chart above, the ADX is on the bottom, in red, and the ADX Slope is in black, above it. Wilder believed that, since the ADX can be used to determine if a security is trending or not, it can help traders choose between a trend following system or a non-trend following system.
Wilder suggested that a strong trend is present when ADX is above 25 and no trend is present when below 20. However, many years have passed and it’s not hard to see that with the ADX, the absolute level isn’t important. What’s important is the Slope of the ADX. When the slope is strengthening, it points at stronger momentum within the trend. When the slope is diminishing, the trend is weakening.
Key point: within a trend, after a strong trending move, the first sign of weakness can accurately be measured by the first decline in the ADX Slope!
Over to You
Traders are usually only concentrated on their price charts. However, price alone doesn’t give traders all the information they need in order to stack the odds more firmly in their corner. The three dimensions of the markets are:
The simple combination of ATR and the ADX Slope capture 2 out of the 3 dynamics in a very simple manner. Once again, don’t think about the precise “system” that has been illustrated. Think about the rationale behind it…measuring volatility consistently, using volatility expansion as a signal, and using market action (the pattern of highs & lows) to gauge trend strength.
If you can reduce your trading system to it’s essence, and understand thoroughlly exactly what dynamics you are capturing, your trading will never be the same – for the better!
About the Author
Justin Paolini is a Forex trader and member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.