How to identify market tops and bottoms with ADX

A great number of Forex technical strategy tutorials on the web suggest that new traders avoid looking for tops and bottoms within a larger trend. There are many occasions where this is sound advice, as this form of contrarian trading will require traders to position themselves against the general momentum in a market, to, in effect, “stand in front of a moving train” or to “catch a falling knife” as this behavior is often described. But even though these are very real factors, it cannot be denied that accurately identifying tops and bottoms in the market will allow traders to enter at the most preferable levels and allow us to “buy low and sell high.”

 

So, the essential question traders should ask themselves is not whether looking for tops and bottoms is a sound approach but rather which method is best for accurately forecasting when a trend has run its course and ready for a reversal. Here we will use a combination of indicators to achieve this: A 20 period EMA, a 40 period EMA and a 14 period Average Directional Movement Index (ADX). In this strategy, all time frames will be considered but trades will only be based on one time frame at a time.

 

ADX as Basis for Reversals

 

The basis for this trade relies on the ability of the ADX to measure trend strength while the 20 EMA acts as a support and resistance level. With this in mind, we look for charts where the 30 is 30 or above, which shows the current trend is strong. Starting with longer term time frames (Daily charts) as these are generally move valid. We can then move to the lower time frames if nothing is seen matching this criteria. If a currency pair shows an ADX over 30 multiple time frames, we opt for the longest term chart.

 

Position Entries

 

After identifying a strong trend, we look for prices to bounce off of the 20 EMA (for buy positions). For sell positions, we look for prices to fail at the 20 EMA. Stop losses can then be set below the 40 EMA, as this area is expected to hold given the underlying trend strength. The difference between the 20 and 40 EMAs also gives the trade some protection against false breaks.

 

Exiting the Trade

 

When establishing trade targets, we use our chart’s Bollinger Bands to identify the standard deviations from historical price action in the currency pair, and then set the profit target to the outside band. What is interesting about this approach is that the profit target can be adjusted later, based on whether or not the Bollinger Band expands or contracts. Always close the trade when prices test the outer Band.

 

In addition to this, a Fibonacci or Trailing Stop method can also be employed when determining profit targets. Fibonacci traders can set targets at the 1.618 extension of the AB move from the previous trend move. In this case, the trade entry effectively acts as point C in the overall price movement. A final method is to simply trail the stop loss once prices move in the forecasted direction. Stops are trailed to just below the previous candlestick low (for longs) or just above (for shorts). The trade is then allowed to unfold on its own until the trailing stop is triggered.

 

Final Points to Remember

Here we suggest that there are three potential methods for choosing a profit target in each trade but it should always be remembered that only one of these methods should be employed at a time. Never start with one method and then switch to another in the same trade. Last, the trade should always be closed if the ADX moves below 30, as this signals the trend as longs its underlying strength. Testing this trade requires active monitoring of the charts, as there are many instances where the trade needs to be adjusted manually. This trading method is not ideal for traders who are generally inactive and rely on previously determined levels.

Below is a Short (Selling) trade example in real time, using a 1-hour time frame, in EUR/USD:

In the example above, Sell positions are initiated when the ADX rises above 30 and prices find resistance at the 20 EMA. The scenario would be reversed for Long (Buy) positions.