Forex- Trading with RSI and ADX in dynamically changing trends

Published: 23rd June 2011
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When to enter the market or take a position and when to exit are the keys. Well, another very important key is where to put the stop-loss orders. In continuously changing market because of high volumes, the first thing we would like to know is what is the trend situation. Once we figure that out then we need to analyze when to enter, when to take profit and at what levels we should put our stop-loss orders.



Keeping a tab on the changing dynamics of the market is very important, specially the ever changing Forex market. No trend lasts forever. In fact the market trends can change very fast. knowing if the ongoing trend is getting stronger or weaker or there is no trend or the trend is very strong help us not only deciding the entry points but also the exits and stop-loss levels. They also help us in deciding whether we should enter for a short-term position or should keep the position for a mid to longer-term with trailing stop-losses and rising our profit taking targets.



Here comes the kit of combination of technical indicators as an important tool.



Here we will try to see how to use the combination of ADX, RSI and moving averages.



We will use Average Directional Index (ADX) and moving averages to decide if the market is good to take a position and to use RSI for deciding about the entry points.



Let's see what could be various possibilities about the trend in the market:



- Strong trend

- Trend becoming stronger

- Trend becoming weaker

- Market is running sideways

- A reversal may be on the way

- A break out from the sideways movement is probable





How to identify the trend:



We will take uptrend as an example.



1) ADX: Check ADX. ADX should be above 25 and rising. This indicates that market is in trend.



2) Exponential Moving Average: The prices closing above Moving Averages (say 5 to 20 periods for short term trading and 20 to 60 periods for medium term trades). So the price action is above the moving average line and we have a rising moving average line. This shows a uptrend. ADX being the same if price action was below the MA line and if the moving average line was dropping then it would have indicated a downtrend.



Now once we identify the trend situation we need to identify the entry and exit and also take-profit targets and stop-loss levels.



Entry point:



Simply speaking we can use various crossover methods like MACD (moving Average Convergence Divergence) line with MACD signal line or shorter period SMA (simple moving average) or EMA (exponential moving average) or WMA (weighted moving average) with longer period of the corresponding moving average line. But lets loop in our friend RSI (Relative Strength Index) here. RSI indicates oversold (hence probable buying levels) and overbought (hence probable selling levels). But will overbought and oversold indications work in strong trending market. Probably not again. But if we apply RSI with the knowledge of the trend as mentioned above then we may have a better platform to take decisions. Here comes the art of combining the technical indicators, here we are talking about combining the indicators which we have mentioned above i.e. ADX, Moving Averages and RSI.



How do we do that?



Lets go back to the above mentioned scenarios i.e.:



- A Strong trend

- The trend becoming stronger

- Trend becoming weaker

- Market is running sideways

- Possibilities of an upcoming reversal.

- Possibilities of a break out from the ongoing sideways movement.



1) Strong trend:



ADX is above 30 and rising. Price closing over 20-periods EMA and EMA line is rising.



The above situation indicates a strong uptrend. We can't wait for RSI to go to oversold position to enter the trade, as RSI can remain in oversold or overbought position for a long time when there is a strong trend. So how to go about in such situation?



1) Entry: Buy when RSI (Relative Strength Index) goes to the range of 68/71.



2) Exit: Close the position to take profit when ADX stops rising and/or RSI moves below 50 and/or price action closes below the 20 days EMA. The take-profit targets mentioned are indicative as the exit also depends on various factors and market situation/volatility. The decisions to close the position need to be dynamic. In strong trends itís always good to keep on raising the take-profit levels and to use the trailing stop-losses.



3) Stop-Loss: Use trailing stop-losses. Stop-losses would depend upon the volatility. if the price movement is quite volatile then the stop-loss would be wide. It could be a few pips below the previous candle's low. as mentioned if the market is very volatile then the stop-loss margin has to be more otherwise even if upward movement continues, the narrow stop-loss margin may close the position with a loss. .



2) Trend becoming stronger:

(letís take the example of uptrend)



ADX above 25 and rising. Price closing above 20 periods EMA and EMA line rising and hence an uptrend.



1) Entry: Buy when RSI (Relative Strength Index) goes below 50 mark.



2) Exit: Exit or take profit when ADX stops rising and/or RSI dips below 40/42 and/or price action closes below the 14 days EMA. As mentioned above, its better to raise take-profit targets with trailing stop-losses in a strong trend. This ensures that we do not come out the market while there was a possibility of further gains.



3) Stop-Loss orders: Use trailing stop-losses. Stop-losses would depend upon the volatility. if the price action is very volatile then the stop-loss would be wide. It could be a few pips below the previous candle's low. As mentioned if the market is very volatile then the stop-loss margin should not be very close to the entry level otherwise even if upward movement continues, the narrow stop-loss margin can close the position with a loss, if price takes some corrective action. Stop loss could be a few pips below the previous candle's low.



3) Weakening trend:



ADX is above 25 but stopped rising. The 20-period EMA is rising but slowly or started running flat.



1) Entry: Buy when RSI (Relative Strength Index) goes below 50.

2) Exit: Exit or take profit price closes below 14-period EMA. The take-profit targets mentioned are indicative as the exit also depends on various factors and market situation/volatility and the decisions need to be dynamic.

3) Stop-Loss orders: Use trailing stop-losses. Stop-losses would depend upon the volatility. if the price movement is quite volatile then the stop-loss would be wide. It could be a few pips below the previous candle's low.



What we saw in the above examples of up trends can be used in downtrends. For downtrend we need to be ensure that the EMA is dropping and price action remains below EMA (opposite to uptrend). ADX only indicates the strength of the trend and not the direction and hence ADX readings should remain same as above example. With all these we can take short-selling position when RSI moves over 50 mark.




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