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BOOK YOUR FREE STRATEGY SESSION NOW >>Today's question: Can we really trust the theory in trading?
Objective: Let's dive into the data to see if one of the most popular indicators in technical analysis actually works as the theory claims.
Get ready for a big surprise!
In this video, we're looking at the ADX (Average Directional Index), designed to measure the strength of market trends.
According to theory, certain ADX threshold values can tell us if the market is trending strongly or moving sideways.
The idea is that by using these values as signals to buy or sell, we should be able to make easy profits.
To put this to the test, we developed a simple ADX-based strategy and applied it to the futures of Europe's largest stock index, the DAX.
And guess what? Our tests revealed something completely unexpected... The theoretical threshold values aren't actually the best for profiting in this market... quite the opposite!
Curious to know more?
Watch the video now to discover why it's crucial to test theory before blindly applying its principles to make money in the markets!
Ready? Enjoy the video! 😉
Introduction: Understanding ADX and its Functionality
Today we’ll create a trading strategy using just one indicator, the ADX, which many of you probably already know since it's a staple in technical analysis.
However, this famous indicator is often used in a way that is neither correct nor useful for achieving optimal results. This isn't just my opinion, but it’s something that’s proven by facts. And in this video, I’ll show it to you by testing this indicator on the DAX future, Europe's leading stock index.
But first, let's understand what the ADX indicator is and how it's typically used by traders.
It was developed by Welles Wilder, an engineer known for technical analysis innovations like RSI and Parabolic SAR.
Unlike those indicators, ADX measures trend strength, which is what we'll explore today.
We’ve already discussed the ADX in a previous video on our channel, where we also explained the formula to calculate trend strength. Watching it is not essential for following this video, but it's worth taking a look because understanding in depth the tools we use for our trading can give us an edge.
Theoretical Insights on ADX Usage
Anyway, what you need to know to follow today’s video is that ADX values range from 0 to 100 and are pretty simple to interpret.
An ADX value that exceeds 25 signals a strong trend, while an ADX value that falls below 20 indicates a sideways market.
That's the theory, and it seems to make sense, but unfortunately, real-world application can vary.
The first reason could be that this interpretation might not apply to today's market. ADX has been around since 1978 and markets have changed a lot since then, so testing is crucial.
I'm one of the coaches at the Unger Academy, and now we’ll dive into the charts to see a strategy example based on ADX.
Putting Theory to the Test: A DAX Strategy
First, a couple of notes. This strategy is designed for daily bars.
In this chart, you see two historical series and that’s for a very simple reason: the first series shows the DAX future on a 5-minute time frame, while the second shows the DAX future on a daily time frame.
We’re using the 5-minute time frame simply because it provides more realistic data but it doesn't fundamentally change anything.
In fact, the strategy is based on daily candlesticks, as we'll see shortly.
At the bottom, you see the indicator we’re using for our strategy development—the ADX.
This indicator is calculated on the daily series, as we're interested in daily bars, and as you can see, it ranges from a value of 0 to a value of 100.
For this strategy on DAX futures, I chose to calculate ADX using 5 periods.
Let's now go and have a look at the script of the strategy, which is quite brief and simple.
First, we have an input and a variable.
The input is a threshold level above or below which we'll buy.
The variable defines the ADX calculated on “data2”, which is the daily series we're interested in.
In the next rows, we have the market entries.
The rules say that if the ADX is above a certain level (which we’ll optimize), we buy at the break of yesterday's high.
Additionally, I've included another condition that sets the “entries today” value to zero.
This condition ensures the strategy opens a new position only if no other trades have been made today.
Finally, there's a “Setexitonclose” command that tells the strategy to close all positions by the end of the session at the latest, which means that this is an intraday strategy.
As you can see, we also set a $2,000 stop loss. Note that this value hasn't been optimized yet and can be adjusted later. Now we added it only to filter out the so-called “outliers”, that is to say, abnormal values that could distort the results.
Strategy Results Using Theoretical Levels
And now the time has come to go and test and optimize our strategy!
Here, as you can see, I’ve already applied it to the DAX chart. So now we’ll go and optimize the ADX threshold value starting from 10 to 100.
Obviously, no trades will occur with 100 since the ADX can't exceed the value of 100.
We'll use a step value of 5 and start the optimization.
Here we have the results. As a first thing, let's look at the value of 25, as theory suggests that an ADX indicator value above 25 indicates that there’s a strong trend going on.
And here’s something very interesting, because the results show an average trade of only $87 and a drawdown of $57,000.
The same bad results are produced with ADX values of 30 and 35.
As for ADX values higher than 40 and 45, the results start to improve a little but they are still unsatisfactory.
Strategy Results with Alternative Levels
So let's change our approach and modify the strategy code.
Instead of entering a position if ADX is above a certain threshold, let's try entering if ADX is below a certain threshold.
Let’s compile the script and start the optimization again using the same settings as before.
And now you can see the results are entirely different and definitely much better!
Most average trades are now above $100-$130, while the drawdown values are certainly lower than before.
But look at the 25 value: by using the ADX threshold in a way that’s contrary to theory, we achieve a great average trade of $350 and a drawdown of $15,000.
Net profit is not amazing yet, since it’s still below $100,000, but that’s partly due to the fact that the strategy makes only 270 trades.
Higher ADX threshold values produce even better average trades and drawdowns, but be careful, since they produce too few trades to be reliable.
So let's go with a compromise value and consider a threshold of 30.
The next step is to go and have a look at an example trade to see how things work.
The ADX value is below 30 and since no trades have been made today, the strategy can buy at the break of the previous session's high.
The $2,000 stop loss isn't hit, so we exit at session close, as specified by the “Setexitonclose” command.
Let's go and see the performance produced by the strategy.
The equity line shows excellent results, especially given how simple this strategy is.
In fact, we haven’t optimized either the ADX period or the stop loss value yet. Actually, we only optimized the ADX threshold value.
The strategy produces an average trade of around $316, which is certainly impressive for such a basic strategy, which still needs further refinement.
Alright, so today we’ve seen that following classic technical analysis rules not always leads to good results.
The Critical Role of Testing Every Setup
For a breakout strategy applied to the DAX futures, entering if ADX is above a certain value, like 25, could be inefficient because that might make you enter when a trend is losing strength and being about to end.
Instead, entering during a sideways phase, which is defined by an ADX value lower than a certain threshold, produces remarkable results.
So this strategy seems very promising and could certainly be further refined by adding a take profit or optimizing stop loss, always paying special attention when choosing the optimized value in order to avoid overfitting. This means choosing the best performers only when they are within an area of stability.
And that's it for today!
If you want to learn more, go and click the first link in the description!
And I’ll see you in our next video, happy trading!
We'll help you map out a plan to fix the problems in your trading and get you to the next level. Answer a few questions on our application and then choose a time that works for you.
BOOK YOUR FREE STRATEGY SESSION NOW >>Andrea Unger here and I help retail traders to improve their trading, scientifically. I went from being a cog in the machine in a multinational company to the only 4-Time World Trading Champion in a little more than 10 years.
I've been a professional trader since 2001 and in 2008 I became World Champion using just 4 automated trading systems.
In 2015 I founded Unger Academy, where I teach my method of developing effecting trading strategies: a scientific, replicable and universal method, based on numbers and statistics, not hunches, which led me and my students to become Champions again and again.
Now I'm here to help you learn how to develop your own strategies, autonomously. This channel will help you improve your trading, know the markets better, and apply the scientific method to financial markets.
Becoming a trader is harder than you think, but if you have passion, will, and sufficient capital, you'll learn how to code and develop effective strategies, manage risk, and diversify a portfolio of trading systems to greatly improve your chances of becoming successful.
