Cut Loss

Combining RSI and ADX
Yet again we have managed to talk a top trader into providing a trading
lessons for our subscribers. Chuck LeBeau is not only a great trader, he is a
recognized authority on trading systems.
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.
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-dat moving average or when the 20-day moving
average turns down. (See entry rule 1.)
by Chuck LeBeau
Chuck Le Beau's System Traders Club

http://www.traderclub.com
[email protected]
Good Trading
Best Regards
Mark McRae

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How does the author suggest combining the RSI and ADX indicators?

What are the entry and exit rules proposed by the author?

Combining RSI and ADX

I like to use the RSI primarily as an indicator for buying on dips in an

In summary, the important concept to remember is that our knowledge of

1. The 20-bar moving average must be rising.

Chuck Le Beau's System Traders Club

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