How To Use Average Directional Index (ADX) Forex Trading Indicator

ADX stands for Average Directional Index. It measures the degree of trend over a given period of time and is a “non directional” indicator.

It is based off comparing the highs and lows of bars and does not use the close of the bar. The stronger the trend, the larger the reading regardless of whether it is an up trend or downtrend. A standard default of 14 is used.

 

When the ADX is low

When the ADX is low, it highlights periods where there is lots of price bar overlap (also called a sideways line or trading range).

There is almost always a corresponding classical chart formation highlighted by a low ADX. This is because chart formations represent consolidation or areas of distribution/ accumulation. Large moves often occur once the market breaks out from these areas.

 

When the ADX has risen above 30

When the ADX has risen above 30, this indicates that the market has picked up enough momentum that any reaction should be followed by a retest. We like to call this the “Holy Grail” trade (as originally described in the Street Smarts book).

The initial condition for a Holy Grail setup is that the ADX rises above 30. Price must then retrace back to the 20-period EMA. Sometimes price can run a bit through the 20-period EMA, but it is expected to find support or resistance around this level. By the time that the price has retraced towards the EMA, the ADX will have turned down. This is OK. The objective for the trade is a retest of the previous high or low area.

Usually there is only one Grail trade in a market per time frame. However, occasionally a second grail set up if a strong trend resumes. The second grail setup is good only if the ADX has risen to a higher level on the second setup than on the first setup. Very often, divergences in the ADX and the market will precede a trend reversal (meaning price makes a higher high but the ADX makes a lower peak).

When looking at intraday charts for grail setups, you will increase your odds of a successful trade if you use multiple time frames. The best trades occur in situations where the ADX level is high on several time frames. The market should always retrace first to the shortest time frame’s moving average.

For example, in a strong up trend the S&P should retrace to the 30-minute EMA first, find support and rally back up. The next retracement will be a bit deeper and pullback to the hourly EMA. After the hourly grail gets its objective, if there is still a rising ADX on the 120-minute chart, then it too tends to get its objective before the trend starts to lose power.

A failed Grail signal is an ominous sign and can lead to a greater move in the opposite direction. Failed grails will occur more frequently when a trader has failed to note that there is not a true trend and in fact, the market is still in an overall trading range environment. Failed grails can also occur if there are momentum divergences on the higher time frame.

It also pays to be aware if there is an OPPOSITE trend on the higher time frame.

For example, if a small 5-minute grail Sale setup occurs when the hourlies are in a very strong up trend with a rising ADX (this has occasionally happened), it is best not to take the 5-minute grail sell.

The last thing to keep in mind is that though this pattern is one of the highest probability trades that can be made, it tends to come late in a trend Thus, play for a smaller objective level and use a tight stop.