Day Trading & Forex Forum

If there is one thing that a trader would want to know for certain, it would be to catch the bottom or top of a trend.

But simple as it sounds, it is easier said than done.

Knowing that a certain price wave is completed, or is just a retracement in the larger trend, becomes more of an art than a science.

In such situations, using multiple sources of confirmation helps to avoid the potential false signals, and preserve our capital for only those situations that provide us with the most favorable risk to reward scenarios. Keeping that in mind, we will use two very different indicators – the ADX (Average Directional Movement Index) and the PSAR (Parabolic Stop & Reverse) - to form a system which should help us to trade as close to the top / bottom as possible.

First we shall look at both the indicators in detail, and find out their characteristics.

The ADX (Average Directional Movement Index)
The ADX is a trend-following system developed by Welles Wilder. Though it can be used as an independent indicator, it t is usually a part of the DMI indicator and determines the market trend.

Therefore, let us also briefly study the DMI indicator. This comprises of two lines – the Plus DI & the Minus DI lines.

The characteristics of the Directional Movement Indicator are: You establish a long position whenever the Plus DI crosses above the Minus DI. You establish a short position, when the Minus DI crosses above the Plus DI.

A simple DI+/DI- crossover is an entry and exit system. However, used that way it produces frequent whipsaws. Hence we combine this with the ADX to reduce these whipsaws.

The ADX thus forms an integral part of this system, as it gives a warning for a market about to change direction. It gives precise interpretations of the price action as follows –

• The ADX tells you if there is a trend present or not. It also informs you if it is early or late in a trend. 
• It informs of a de-trending, of a reversal and renewal. 
• The ADX however does not indicate the direction of the trend, only the strength of the trend.

Now in our chart here, we have the red line as the minus DI, the blue line as the plus DI, and the green line is the ADX. I have drawn a line at the 20 level for the ADX, since the rise of the ADX above 20 signifies an emerging of a trend.

Overall if we observe only both the DMI lines (the blue and the red) it does give a correct picture of the trend, and keeps us in the correct side of the market.

Simply put, at the area marked with the red line, the –DMI line is above the +DMI line, signifying a downtrend.

And at the area marked with the blue line, the +DMI line is above the –DMI line, signifying an uptrend.

But what about the areas, where the DMI lines have frequent crossings. This is the kind of situation which will whipsaw out any position and this where the ADX is used in tandem.
The indication for an entry into a trend is when the ADX starts rising from the lows. And ideally the ADX should be pointed up at all times when entry is being considered

But we are concerned right now with the end of the trend.

The turning points in markets are often heralded by turns in the DI+/DI- at upper and lower extremes shortly followed by a down turn in the ADX. This setup is near coincident with major turning points.

Thus the conditions for exit are - 

• The DI+/DI- lines should show signs of declining momentum at their extreme levels, by turning down.
• These lines should cross the rising ADX line down.
• We look to exit the trade only when the ADX line starts to fall down. 
• The subsequent crossover of the DI+/DI- lines would give us an additional confirmation of the change in trend.