Breakout Trading Using the ADX on FutureSource Workstation / eSignal

A popular trading method is the basic breakout strategy whereby a trade is executed on the long or the short side when prices have moved out of the recent trading range. For the purposes of this article, I’ll outline a channel breakout strategy. However, breakouts can also appear in a market that has been trading in an upward or downward sloping fashion.

There are many different ways to identify when the market has made a channel break. One of the more common is to buy a 20-day high or sell a 20-day low. The general rule is that the price bar must CLOSE on a new high or low -- not just penetrate the previous 20-day high or low. Ah, but I hear you ask, “What about all those annoying false breakouts?” 

The following method can alleviate the problems and frustrations associated with a high or low tick due to stop loss activity rather than the potential commencement of a trend.

If the market travels sideways in a relatively tight range for 20 days, one can expect that volatility is generally low. 

My favorite strength-of-trend tool is, of course, the Average Directional Index (more commonly known as the ADX). This little beauty will keep you out of many trades that turn out to be false breaks. 

This is how it works: To start with: The ADX has nothing to do with direction. It simply tells you whether the market is trending or not or if it is about to commence a trend. In your charting software, the ADX line is hidden away within the indicator called the DMI or Directional Movement Indicator. The DMI will provide the direction, as well as display the ADX line. However, I personally “toggle” off the DMI component because I find it visually a bit messy. 

On a daily chart, I suggest using 4- and 11-period Moving Averages (MAVs) to provide the directional signal when they cross. A cross of the 4-period MAV from below and up through the 11-period MAV means that prices are now advancing or moving higher at a faster rate than they have been -- the opposite is true for a sell signal.

The question here, however, is when to take the trade? I find that you can stack the odds in your favor when the ADX has moved up for 2 periods between 20 and 30 on the Index. The ADX line can come from below 20 on the first move up but the second-period move higher must be above 20.

A falling ADX line or a sideways ADX means that the market is not trending or, perhaps, has completed the previous trend. Moves below 20 are generally false moves and should be ignored.

OK, then, the ADX has moved up two days or bars (if you’re intraday trading) as per the previously described guidelines, and the MAVs have crossed to give a buy signal.

You must then BUY on the open of the next bar and place your initial stop halfway between the range that the market has just broken out from. The size of the previous range will, of course, determine the dollar value of the stop loss, so it will be the size of your account that determines whether you should do the trade or not. (You should generally risk only 5 percent of your capital in any one trade.) 

The opposite is true for a sell signal. As the market moves in your favor, trail the stop up, using your own money management techniques to lock in profit.