Developing an ADX Based Strategy... My First Non-trend Following System

If you have followed my blog for a while you may remember my post some time ago about the ADX indicator as a part of the "indicator series". If you have never read my blog before or you have never seen these posts, these articles attempt to describe the mathematical meaning of different indicators and how these indicators can be engaged in automated trading for the development of long term profitable systems. The main objective with these posts is the real understanding of the underlying math behing the indicators and what they truly mean. It is my firm belief that absolute understanding of any indicator is necessary if a person wants to use it successfuly in any trading system- indicators are not just lines drawn on a screen - they are calculations done over price which give us important information about price action. However, in order to understand this information we need to understand the truth about the calculations. On today's post I want to share with you my initial developments on the design of an automated trading strategy dealing with the ADX indicator and how it manages to achieve a good like hood of being long term profitable.

If you remember my post about the ADX I said that this indicator is usually not used properly as it does not "signal" the difference between ranging and trending market conditions and using it as a "filter" usually only leads to worse performance and a diminishemnt in the statistical significance of a system expressed as a reduction in the number of trades. However I talked about ways in which the ADX can be used successfuly to develop a trading system, particularly how it can be used to detect retracements and enter trades after a trend has partially reversed. However I then realized that there might be good potential to use the ADX to exploit consolidation periods in trading instruments, reason why I decided to try such an approach and see what I could get.

The strategy used is very simple, the system waits until the ADX reaches a level above 50 to "detect a trend" and then the expert advisor waits for a drop below the 20 level in order to enter a trade in the direction opposite to that of the trend. This means that the EA will actually assume that after the ADX reaches extreme levels and drops, a reverse movement in the form of a consolidation is bound to be happening. The EA is able to achieve high profits in periods where trends develop strongly and then consolidate. The fact that high ADX levels have to be reached for trend detection with a subsequent drop protects the EA from entering trades when strong trends are developing since a drop in the ADX is unlikely until a consolidation periods is reached. Note that this is not the usual way in which the ADX is used and the design of the strategy comes from an understanding about the mathematical meaning of the indicator.
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The implementation of this system- without any optimization of any variables- leads to the results shown below. Positions exits and lot size are adapted against volatility using the 14 period daily ATR and the ADX 10 period indicator on the one hour charts is used. Results are very good preliminary results for a trading system pointing out that there is great potential for long term profitability. The system is able to successfuly adapt to changes in market conditions and with this it is able to remain profitable. It is very worth noting that without the ATR adapted SL, TP and lot size this system is NOT profitable, again it is very important to say that entries merely determine the potential of a trading system while the exits used determine a system's profitability. (Backtest was done from Jan 01 2000 to Jan 01 2010, TP and SL values are 50% of the daily 14 period ATR so interpolation errors should be almost non existant)
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There is still a lot of room for improvements, mainly through the addition of internal closing mechanisms based on logic around the same ADX indicator something which should take this expert advisor to the level of Watukushay FE and other trading systems developed within the Watukushay project. I have to point out that this EA is an achievement for me in the sense that it is the first time I am able to develop a likely long term profitable system exploiting a market inefficiency different from that of pure trend following. Will this inefficiency be exploitable to a significant extent ? Will such a trading approach have the same potential of trend following ?

I will try to answer these questions during the following few months as I continue to develop this system and analyze its trading results. If you would like to learn more about the Watukushay series of expert advisors and how you too can develop your own long term profitable systems based on sound trading tactics please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !