Trading with ADX and RSI Combination

How Success in Forex trading can be achieved by monitoring changing market trends using technical analysis indicators. By using the Average Directional Index (ADX) to determine the strength of any tendency to trend, and the Relative Strength Index (RSI) to determine over-sold or over-bought situations, you should be able to identify winning entry and exit points for successful trading.

Forex trading involves dynamically changing markets, and it is of extreme importance that you can determine whether a winning trading position is possible, and that you identify the exact entry and exit points required for success. The Average Directional Index (ADX) should be used to determine the direction the market is taking, and once that has been established then the Relative Strength Index (RSI) can be employed to determine when to buy and when to sell.

The more accurately you are able to identify the entry and exit points, the more successful your Forex trading will become. In view of the accuracy needed to make the correct decisions, it is unlikely to be advisable to base these decisions on just a single technical indicator. Forex markets are so dynamic that trends can change significantly during the life cycle of even a single trade.

Your important trading decisions will be based upon the undernoted trend scenarios:

• A strong trend
• Trend weakening
• Trend strengthening
• Trend moving sideways
• Trend tending to reversal
• Trend breaking out from a sideways movement

It is apparent, therefore, that the trend must be identified before you can make a buying or selling decision. The undernoted tools can be used together to enable you to correctly identify the trend situation and also identify an entry and exit position:

ADX above 25 and rising
If we assume prices closing above the moving average of 5-20 periods for short term and 20-60 periods for medium term trades, then we have a rising moving average with the price action above it - an obvious uptrend. A downtrend situation would be if the price action was below the moving average, because the average would then drop.

Having identified an uptrend, you now have to decide on the entry and exit points, and also levels for take-profit and stop-loss. In order to determine the entry point you could use a number of crossover techniques such as the Moving Average Convergence-Divergence (MACD), graphing the difference between 12 and 26 period EMAs (Exponential Moving Averages) over different periods, with an MACD signal line.

However, let's instead look at the RSI that shows you oversold and over bought levels that indicate likely buying and selling levels respectively. Although it unlikely that these will offer accurate results in a strong trending market, knowing the trend will enable you to make a much more informed and intelligent decision. To do that, you will make use of the indicators we have discussed: Moving Average, ADX and RSI.

To discuss this, you should refer back to the 'possibilities' list above and we shall refer to each in turn.

1.  Strong Trend:

Let's consider the situation of an uptrend: ADX over 30 and rising.  The price closes over 20 periods EMA, with the EMA line rising. Assume a strong uptrend, then you will miss the boat for buying if you wait until the RSI gets to 'oversold' before entering. So what should you do?

a)  Entry point: buy when RSI reaches 68-70.
b)  Exit point: take profit when the ADX level or the RSI drops below 50, or if the price closes at less than the 20 days EMA. These targets should be used only as a guide, since your exit will also depend on a number of other factors such as the market situation or its volatility, and the decision is a dynamic one, not based on one single indicator. You should employ rising take-profit levels and trailing stop-loss situations with strong trends. 
c)  Stop-Loss: employ trailing stop-losses. These are dependent on volatility, and with a volatile price movement the stop-loss should be wide. It can be several pips before the low point of the previous candle of your candlestic chart. The more volatile the market, the more the stop-loss margin because even a continued upturn could still result in an overall closing loss.

2.  Trend Becoming Stronger 

As 1, above, but with the ADX at 25 and rising.

a)  Entry:  Buy when the RSI drops under 50. 
b)  Exit: Take profit when the ADX either stops rising and/or the RSI drops below 40-42, or the price action dips below the 14 -days EMA at closing. This is an indication only for the same reasons as explained in 1-b above.  
c)  Stop-Loss:  Again, trailing stop-losses. Again, they are dependent on volatility, and widen with increasing volatility. The same considerations apply as with the strong trend re the previous candle's low point: to avoid a potential loss with a very volatile market, the stop-loss should be a few pips above that. 

3.  Weakening Trend:

The ADX is above 25 but static, while the 20-period EMA is slowly rising.

a)  Entry:  Buy when the RSI is below 50.
b)  Exit:  Take profit or exit when the price closes under the 14-day EMA. Again, the comments regarding this being for guidance only apply, together with the need for dynamic decisions in a volatile and indeterminate market. 
c)  Stop-Loss:  As the comments in 1-c and 2-c above.

During a downtrend, a short position can be taken with a dropping EMA and prices are closing below EMAs as opposed to an uptrend, when EMAs are lower than closing prices. Because the ADX in an average directional index, it will not change since it does not indicate direction as such, just the strength of the trend. When RSI goes over the 50 mark, you can take short-position.

These are just a few ways in which technical analysis indicators can be used to help you enter and exit Forex markets at the appropriate times. The same concepts and principles can be used for other trends, the secret to Forex success being perfect timing. 

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