In this article we will see how the Average Directional Index (ADX) and Moving averages may indicate that we can take a trading position and Relative Strength Index (RSI) and MACD crossover to indicate the entry/exit point.
In Forex trading the volatility in general is quite high and the trends can change very dynamically. Uptrend to sideways move to downtrend to uptrend may take place even during one life cycle of a trade. Of course we are not talking about trades where we enter and close within hours.
Combining selected technical indicators comes in handy is such dynamically changing markets.
It is always better to combine the chosen technical indicators for the trading decisions. While we talk about combining we are not talking about selecting similar indicators to cross check on each other.
Before we take our trading decisions, we need to analyze the Trend situation:
– Is it a strong trend?
– Is the trend becoming stronger?
– Is the trend becoming weaker?
– Is the market running sideways without a clear trend
– It has been a trend but a reversal may be on the way
– A break out from the sideways movement is probable
Trend identification is one of the important starting points before taking a position.
How to identify the trend:
ADX: ADX above 25 and rising
EMA (for uptrend): The prices closing above Moving Average (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. And 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 decide on the entry and possible exit. Apart from entry we also need to think about stop-loss levels and targets for taking profit. Lets start with entry point.
As far as entry point is concerned we can use various crossover methods like cross over of MACD with signal line or shorter period SMA (simple moving average)or EMA (exponential moving average) crossover with longer period of the corresponding moving average line. But lets bring in RSI (Relative Strength Index) here. RSI indicates overbought (hence probable selling levels) and oversold (hence probable buying levels). But will overbought and oversold indications work when the trend is very strong? Well the answer would be “Not”. But if we apply RSI with the knowledge of the trend as mentioned above then we may be able to take better decisions.
So let’s see how to combine technical indicators. We are talking about combining the indicators which we have mentioned above i.e. ADX, Moving Averages and RSI.
Lets consider the following scenarios:
– 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
1) Strong trend:
ADX is above 30 and rising further. Price action is continuously over 20 periods EMA and EMA line is rising.
The above indicates a strong uptrend. We can not wait for oversold and overbought signals from oscillators such as RSI in strong trends as the price can be in overbought area for long in strong uptrend and vice versa. So how to go about entering the market in such situation?
1) Entry: Buy when RSI (Relative Strength Index) goes to the range of 68/71.
2) Exit: Exit the buy position i.e. take profit when ADX stops rising and/or RSI drops below 50 and/or price action closes below the 20 days EMA. The take-profit targets mentioned are indicative as the exit depends on market situation/volatility and the decisions need to be dynamic. In strong trends it is advisable to use trailing stop-losses and rising take-profit levels.
3) Stop-Loss: As mentioned above its is better to use trailing stop-losses. Stop-losses levels even with trailing levels would depend upon the volatility. if the price movement is quite volatile then the stop-loss margins would be wide. We may decide to put a stop loss a few pips below the previous candle’s low. We can also use SAR (stop and reverse) indicator to indicate the stop-loss levels. 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 getting stronger:
(lets consider an uptrend)
ADX is above 25 and rising. Price is closing over 20 periods EMA and EMA line is rising. This gives an indication that its an uptrend and the trend may become stronger.
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 goes below 40/42 and/or price action closes below the 14 days 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 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. As mentioned in above example we can use SAR to indicate the stop-loss levels.
3) Trend getting weaker:
ADX is above 25 but not rising. The 20-period EMA is getting flatter.
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 and 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.
In the above examples we have considered an uptrend. During the downtrend we can take short-positions when the EMA line is dropping down and price action remains below EMA, which is opposite to uptrend. ADX readings should remain same as above example because ADX reading only indicates the strength of the trend but not the direction. And we can take short-position when RSI (Relative Strength Index) moves over 50 mark.