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AB users:
I copied this article from Chuck LeBeau's website this morning
(www.traderclub.com). It's an interesting combination of 2 indicators
into a trend-following system for EOD data users. Seems like the
system should be easy to code in AB. I haven't done so yet, since I'm
writing this from work.
Al Venosa
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The Traderclub Forum: Traders Club Bulletins: Bulletin 52
Combining RSI and ADX
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By webmaster (Admin) on Monday, October 7, 2002 - 07:12 pm:
BULLETIN #52
Combining RSI and ADX
By Chuck LeBeau
Now that I am spending seven hours a day doing trading for
the new hedge fund I haven't had much time for research or
writing new Bulletins. However a comment in one of the
trading newsgroups that I monitor got me thinking about the
potential benefits of combining our knowledge of RSI and ADX
into a simple system. Both the ADX and RSI are valuable
trading tools and a combination of the two would seem to
offer some interesting possibilities. I like to use the RSI
primarily as an indicator for buying on dips in an uptrend.
The ADX is my primary indicator of trend strength.
Here are a few ideas on how the two indicators might
compliment each other in a system that "knows" when to enter
on strength and when to buys on dips. (I'm only going to use
the long side for examples but the logic should apply to
short trades as well.)
When the ADX is rising it usually indicates that a strong
trend is underway. In many cases waiting for any sizeable
dip would be costly because the market could run away and
the dip entry would be too late to maximize our profits. In
this case we must enter on strength. To make this idea into
a simple trading rule we might state that if the ADX is
rising (and we have some indication it is rising because an
uptrend is underway) we will buy whenever the RSI is below
some very high threshold like 85. This rule would give us a
very prompt entry in most cases and the result would be
almost identical to simply trading whenever the ADX is
rising which seems to be a good idea. The RSI has little,
if any, benefit in this situation except it might
occasionally keep us from buying into an extremely
overbought market where the RSI was above 85. In this case a
slight delay on the entry might be prudent.
The RSI, however, can play a much more important role when
the ADX is flat or declining. In this case the rule would
be that when the ADX is not rising we should postpone our
entry until the RSI is below some more typical threshold
like 45 or 50. Since the ADX is not giving us a signal that
the trend is unusually strong we would need some additional
indicator to show that the market has some minimal amount of
upward direction. Otherwise we would not be buying a dip
within the framework of an uptrend. Something simple like
an upward sloping 20-bar moving average might work in this
application.
Now that we have combined the ADX and RSI for our entries we
might also want to combine them for our exits. When a
market is rising but the trend is not particularly strong
any spike in the RSI represents a good opportunity to take a
profit. For example when trading in stocks the 9-bar RSI
rising above 75 or 80 often signals that a correction is
imminent. If the market trend is not unusually strong we
would probably be happy with taking our profit on strength
rather than waiting to get stopped out on weakness. However
if the ADX is rising we might want to risk a correction in
hopes of riding the trend even further. In this case when
the ADX was rising we would ignore the RSI signal to take
our profit. However, once our patience has allowed us to
accumulate a very substantial open profit we might be best
served by acting on the next RSI signal and nailing down the
big winner. Also, when the ADX is rising it would not make
much sense to be buying at a high RSI level and also selling
at a high RSI level. We would be in and out of our trades
almost immediately. Therefore we need to ignore the RSI
extremes until our profit has had a chance to accumulate.
In summary, the important concept to remember is that our
knowledge of the ADX can make the RSI a much more useful
trading tool. When the ADX is rising the RSI tends to get
overbought and it can often remain overbought for a
surprising length of time. On the other hand when the ADX
is flat or declining any spike to the upside in the RSI is
an opportunity to nail down a profit. Conversely, any spike
to the downside can be a potentially profitable entry point.
Here is the logic of a simple little system based on this
discussion. (Just the rules in text form, you will have to
do your own coding.) The parameters selected have not been
tested or optimized. For example the 20-day moving average
is just a number I picked out of the air. This is enough
information to get you started and you can vary the rules to
make the system trade over whatever time frame you prefer.
Long Entries:
1. The 20-bar moving average must be rising.
2. If the ADX is rising (ADX today is 0.20 or more higher
than yesterday) then buy if the 14 bar RSI is less than 85.
3. If the ADX is not rising (ADX today is not 0.20 higher
than yesterday) then buy if the 14 bar RSI is less than 50.
Here is where you can influence the frequency of trading.
For more trades use a higher threshold like 60. For fewer
trades use a lower threshold like 40.
Long Exits
1. If the ADX is not rising (ADX today is not 0.20 higher
than yesterday) then sell (long exit) if the 9-bar RSI is
greater than 75.
2. If the ADX is rising (ADX today is 0.20 or more higher
than yesterday) and the open profit is greater than (pick
some amount - maybe 4 ATRs or some unit of price) then sell
if the 9-bar RSI is greater than 75.
3. You need some additional exit rule for the losing trades.
Use your favorite loss-limiting exit or you might want to
exit when the price goes below the 20-day moving average or
when the 20-day moving average turns down. (See entry rule
1.)
Good luck and good trading.
Chuck LeBeau
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