The ADX Continuation strategy which I have outlined below along with its results back-tested over the last 12 years, combines the use of a simple 3-bar continuation pattern, the Average Directional Movement Indicator (ADX) and the Rate-of-change of the ADX. It performs best when traded traded on the EUR/USD pair but it also works quite well on GPB/USD and USD/JPY.

The advantage of this strategy is that is combines both a high probability success rate and a low risk-reward ratio. The probability success rate is over 80% and the risk reward ratio is 1.0:1.4. The disadvantage is that the set-up is rare and the sample on which the results are based is small. Over the last 12 years the set-up has only occurred 17 times on EUR/USD with 15 winners and 2 losers. Nevertheless I am confident that the principles on which it is based are sufficiently robust to indicate it will continue to work well in the future.

In addition it has now taken the lead position in our hunt for the holy grail of Forex trading project, showing better performance even than the Golden Cross MA ROC strategy which was previously at the top spot.

The Set-up

A 3-day – or bar continuation pattern provides the signal which lies at the core of the strategy. This pattern is composed of a strong bullish up-day, a doji in the middle and a strong bullish third up-day. The doji-like bar is sandwiched in between the two other bars.

Below are the rules for the set-up. The numbers refer to the bars, with No 1 indicating the first and lowest bar and 3 the last and highest. This strategy works best on a daily chart.

Rules for the continuation pattern:

1. Close of 2 is more than Close of 1
2. Close of 3 is more than Close of 2
3. The body of 1 must be more than 50% of its range
4. The body of 3 must be more than 50% of its range
5. The body of 2 must be less than 50% of the length of the body of 1 and the length of the body of 3. The high of 3 must be the highest high of the group
6. The low of 1 must be the lowest low of the group
7. The length of 3 must be at least twice the size of the length of 2

The picture above shows an example of one of these 3-day patterns with arrows to illustrate the different days and the final day 3 illustrated with a white outline. As can be seen in this example the pattern acts as a very good indicator of continuation of the established up-trend.

How to trade?

The pattern is a bullish continuation pattern which we want to use as a signal for entering a long or buy position and riding the trend higher. The rules for trading are to place a  buy order one pip above the high of day 3, which is the one outlined in white. The stop-loss is placed one point below the low of the same day, day 3 – or the white bar. The target  for the  strategy is 150 points on EUR/USD.

The use of ADX

The 3-day pattern above works quite well on its own but next set of criteria are used to refine the set-up and filter out the weaker et-ups from the best quality trading opportunities. They use ADX and Rate-of -Change (ROC) of ADX.

What is ADX?

For those who are new to trading ADX is an indicator which helps distinguish trending from sideways  or consolidating markets. When ADX is over 20  then it indicates the security being analysed is probably in a trending state. When ADX is below 20 then it indicates the security is probably consolidating. ADX is short for Average Directional Movement Index. It was developed by Welles Wilder the Technical Analyst who developed the RSI indicator and Parabolic Sar.

In this strategy we use ADX to help filter out higher probability set-ups. In order to do that we need   to look for an ADX reading on a setting of ADX(14) of over 20 occurring simultaneously with a the 3-bar set-up described earlier.

All trends end eventually and when ADX reaches above 50 it is usually a fairly good indication that we are near to an overbought extreme. Indeed it appears that even above 35 the chances rapidly increase that the security will at the very least pull-back and this could take out our stop.  Therefore another criteria we can use to filter out higher probability set-ups is to only trade set-ups when the ADX is below 35.

To conclude, therefore, the ADX needs to be between 20 and 35 when a 3-bar continuation pattern finishes forming on the daily chart.

ADX ROC

Rate-of-change of ADX is the Rate at which ADX advances or declines. It is a proprietary indicator  developed by finding the Rate-of-Change of ADX. In this strategy we use it to help highlight which of the ADX readings between 20-35 are optimum for the likelihood of signalling a continuation higher. It provides a further criteria for filtering out the higher probability set-ups from the less probable set-ups.

It has been found that when ADX ROC on a 4 bar setting is showing a value above zero the set-ups which occur are more likely to be successful. This is the final criteria in our strategy – ADX ROC must be above zero for us to take a trade. This is illustrated below using the same set-up in the picture for the continuation pattern:

The chart above shows several ADX Continuation set-ups which full-fill all the criteria above, on a daily chart of EUR/USD.  The bars outlined in white indicate valid continuation patterns.  They are outlined in white because of a programme I have written to indicate them. Underneath the price action are the other two indicators we use for the strategy ADX and ADX ROC. The zero-line on ADX ROC is shown by the blue centre-line running through the middle of the oscillator.

Starting from the left we can see a white bar with an arrow pointing at it labelled “Invalid Set-up B”. This shows a set-up which conforms to all the criteria for the 3-bar continuation pattern but fails to meet the criteria for ADX and ADX ROC. This is because ADX is above 35 and ADX ROC is below the blue zero-line. We would therefore ignore this set-up and not trade it.

The next set-up occurs in the middle of July. This time the pattern is valid because it meets all our criteria: ADX is between 20 and 35 and ADX ROC is above 0. We would therefore trade this placing a buy order at the high of the 3 rd day and a stop at its low. It would have successfully made 150 points.

The pattern on the 26 th likewise is valid and leads to a good continuation higher as well, also making its 150 point target. The pattern at the end which is invalid because the ADX is just above 35 fails to reach its 150 point target so it was just as well that we didnt trade it.

Strategy Results

Below is a guide to the results we would get trading the strategy generated by a computer programme back-testing the strategy over the last 12 years on EUR/USD using a standard lot. It shows how incredibly successful  the strategy is, with a high 88.34% probability success rate and higher average win to loss. The results are based on trading the strategy on Tradestation and results may be different on Metatrader or another package, although they should all show a successful track record and only minor variance.

One difference between packages can be the ADX.  Its result can differ depending on different platforms because they have different session-end times. ADX on Metatrader uses a slightly different calculation compared to Tradestation. Traders can carry out their own testing before trading this and experiment using different levels and parameters – the above rules are a firm guide but not set-in-stone.