As an options trader, don’t you think it would be nice to have a way to know when a stock price is most likely to move sideways for a while? This guide shows how the ADX indicator can help you set up Iron Condors more effectively and offers free backtesting tools to review past stock behavior for better trading decisions.
Key takeaways
- The ADX indicator helps identify trending markets and stationary phases, aiding in more effective Iron Condor setups.
- You can use the ADX indicator and Option Samurai to find an iron condor opportunity and check how these stocks behaved in the past in similar conditions.
- We offer a free backtesting file to check what happened to any stock price in the past based on the value of its ADX indicator. This allows you to have more confidence in a trade and make a more informed decision.
What is the ADX Indicator?
The Average Directional Index (ADX) is a technical analysis indicator used to measure the strength of a trend in the market, regardless of its direction. Developed by J. Welles Wilder, the ADX helps traders identify whether a market is trending or ranging.
How the ADX Measures Trend Strength
Here is what the ADX indicator on Apple (AAPL) looks like:
- Calculation: The ADX is derived from two other indicators: the Plus Directional Indicator (+DI) and the Minus Directional Indicator (-DI). These indicators compare current highs and lows to previous period highs and lows. Note that, for simplicity, the image above does not feature the positive and negative components of the indicator, but only the indicator itself.
- Values: The ADX typically ranges from 0 to 100. Values above 20 usually indicate a trending market, while values below suggest a lack of trend or a ranging market.
- Strength: A rising ADX indicates strengthening trend momentum, whether the market is going up or down. Conversely, a falling ADX suggests weakening trend momentum.
Importance of ADX in Trading Strategies
- Trend Identification: For Iron Condor strategies, knowing whether the market is trending or ranging is crucial. The ADX helps traders decide when to enter or avoid trades based on trend strength.
- Setup Optimization: When the ADX shows a low value, it indicates a ranging market, which is ideal for Iron Condors. Since Iron Condor strategies profit from low volatility and minimal price movement, using the ADX can improve the probability of success.
- Risk Management: By incorporating the ADX into their trading strategy, traders can better manage risk. It allows them to avoid entering Iron Condor trades during strong trends that might lead to significant losses.
How to Use the ADX Indicator to Gain an Edge with Iron Condors
So, how do you use the ADX indicator to gain an edge on the market with iron condors? Well, before writing blog articles, we are also options traders, so let us tell you more about our intuition.
The Average Directional Index (ADX) is a technical analysis tool that measures the strength of a trend in the market. It ranges from 0 to 100; values above 20 generally signal a trending market, while values below 20 indicate a ranging or weak trend. Note that this is not a rule set in stone: traders may very well choose to combine the ADX with other indicators to refine trading decisions, and they may choose to use different ADX thresholds for different stocks or timeframes.
How the ADX Measures Trend Strength
- Trend Strength: The ADX helps determine whether a market is trending or not. A rising ADX indicates increasing trend strength, while a falling ADX points to decreasing trend strength.
- Non-Directional: The ADX doesn’t show the direction of the trend, only its strength. This makes it useful for identifying both bullish and bearish trends.
Using ADX with Iron Condors
- Ideal Market Conditions: Iron Condors perform best in low-volatility, non-trending markets. By using the ADX, traders can identify these conditions and avoid periods of high volatility.
- Entry and Exit Points: Traders can use the ADX to time their entries and exits, ensuring they engage in Iron Condor trades when the market exhibits weak trend strength, enhancing the probability of success.
- Our intuition: Suppose you spot a stock with an ADX that has very recently moved below the 20-level, indicating a shift from a trending market to a ranging one. In that case, this might be an excellent time to consider setting up an Iron Condor trade on that stock. There you go: this is the idea we want to explore in this blog article (and spoiler alert: historical data analysis shows that this is a rather good strategy, but we’ll tell you more about that below).
Trading Iron Condors Backed by ADX Analysis
We want to quickly look at a typical result you could obtain with our backtest based on the ADX indicator. Through the “High probability iron condors” predefined scan on our website, you may find this trade opportunity on PYPL:
- Buy: $50 put
- Sell: $52 put
- Sell: $66 call
- Buy: $68 call
- Expiry: 38 days
And here it is for you, directly from our options scanner:
Note the $47 maximum profit, compared to a maximum loss a little above $150 on both sides of the trade. In short, you want PYPL to trade between $51.53 (-14.30% from the current price) and $66.47 (or +10.54%) during the next 38 days to have a profit. The fact that you may earn $47 against a maximum loss of $151 means that your profit ratio here is slightly above 31%.
Why Pick This Trade?
There are many reasons to pick a trade such as this one. Suppose, for instance, that you like PYPL because it’s a fairly predictable stock. Although technically classified as a tech company, it behaves more like Visa and Mastercard, acting as a payment gateway rather than a tech firm, meaning that its price is not very volatile, with a beta generally below 1.5. As we showed you above, the breakeven points of this strategy are far apart, making it a good probability trade.
We’re not going to show you the input values you should give the Google Colab file in this section, as we only want to focus on an example of the result. Don’t worry, we’ll guide you through each necessary step to create your own analysis later in the article.
For now, consider this first analysis output: PYPL’s ADX indicator moved below 20 a few days ago, and, on average, it stays below 20 for about 11 days. This means you can expect PYPL to remain relatively calm over the next couple of weeks.
Next 38 Days Movement
Now, if you are like us, just knowing the two numbers mentioned above isn’t enough. You probably want to know how PYPL tends to move over the next 38 days (remember, your options expire in 38 days) after entering a sideways trend situation (as measured by the ADX dropping below 20), and here it is:
This is what happens after the ADX moves below 20 for PYPL. Here is a breakdown of what you should understand from the chart above:
- The average price (blue line) moves sideways for the first couple of weeks and then moves down for another couple of weeks.
- Note that we’ve also added a statistical confidence interval of 75% (the blue area)
- The average cumulative price change in PYPL on a normal day (the black line) is there to act as a benchmark for your analysis.
- The red lines simply indicate your breakeven prices (in percentage terms): you will need the stock to remain between these two lines to have a profit.
During the first two weeks, you can expect the ADX indicator to stay below 20 (approximately 11 business days on average). However, beyond this period, a trend usually manifests, often slightly negative.
It’s important to note that the 11-day average statistic is just that—an average. There have been cases where the ADX remained below 20 for much less or much more than 11 days, and vice versa, as you see below (refer to the highlighted periods):
This is not an oracle; keep your trade under control and ask yourself daily: “Should I close the Iron Condor earlier or wait for my options to expire?”. The answer is far from trivial, as sometimes closing an iron condor before it expires is likely the best choice you can make. Therefore, this is a good trade setup, but it’s not perfect, as the average sideways trend for PYPL is much shorter compared to the options expirations. Otherwise, this would be a perfect trading idea.
Using Our Backtest File
After the very quick PYPL example above, we want to take a little bit more time to guide you through every step of the way. We’ll teach you a new way to select iron condors using our backtest file.
Step 1: Finding a Trade Idea
Let’s assume you find a cool trade idea on our options screener, such as Medtronic (MDT). Suppose this is a stock you’ve traded in the past and know that MDT has a low beta (< 1). You notice that the stock’s ADX indicator seems lower than usual, making it a good opportunity to trade an iron condor. Remember, an iron condor strategy profits if the stock price doesn’t move much over time.
This is the trade idea, for full disclosure:
We’re basically saying that, with MDT trading at $80.41, you’d do the following:
- Buy a $76 put
- Sell a $77.5 put
- Sell an $87 call
- Buy an $87.5 call
Note that all these contracts have the same expiration date (23 days from now). Your breakeven points would be at $77.10 (-4.12% from the current price) and $87.40 (or a +8.69% price change). On the downside of the trade, you’d be losing $110, while you’d lose $10 on the upside of the chart. Between the two prices mentioned above, you’d earn $40. This means that the maximum return on margin would be 36.36%, or 570.23% if you annualize the number.
Step 2: Entering Trade Details in the Backtest
Now, enter the details of the trade in the backtest file:
- Ticker: MDT
- Lower Breakeven Point: -4.12%
- Higher Breakeven Point: +8.69%
- Days to Expiration: 23 days
You can also choose the starting year for your historical analysis. For example, you might select 2019, but you could input 2021 to avoid including periods like the Covid-19 pandemic. Typically, the 20 threshold is used to differentiate between trending and sideways markets in the ADX indicator, but you can adjust this if you have a better idea:
Step 3: Running the Backtest
Go to the “Runtime” tab at the top of the file and click the “Run all” button. In a few seconds, you will have the results you need.
Which Results Will You Receive?
Once the backtest runs, you will be provided with several key pieces of information:
- Historical Performance: How MDT has performed historically when its ADX was below the specified threshold.
- Average Days Below Threshold: The average number of days MDT stays below the ADX threshold you set.
- Price Movement Analysis: How MDT tends to move during the specified period (e.g., does it trend sideways or slightly up/down?).
The section below will teach you to interpret the analysis results soundly.
A Real-Life Example of ADX-Based Iron Condor Trade
Now that you have a general idea of how to set up our backtest file based on a trade you found on our options scanner, let us guide you through the results we obtained on the MDT stock. Of course, this is where the value of the trader’s experience is vital: we will give you our own interpretation of the analysis output, but there is no reason why you should not disagree or give a slightly different interpretation to it.
Key Analysis Outputs
First of all, focus on two sentences that our analysis will give you:
- The last time the ADX indicator moved below 20 was on 2024-06-25.
- Note: on average, the ADX indicator remains below 20 for 10.09 days.
This means that:
- The ADX indicator for this stock moved below 20 just yesterday.
- The ADX indicator remained below 20 for an average of 10 days in the past.
So, how does the price of MDT change, on average, once the ADX moves below 20? As you see from the chart below, not much:
Note that we have added the average price change (in blue) with its 75% confidence interval (the blue area). We have also added the two breakeven thresholds (the red horizontal lines) and the average price change of the stock on a normal day, ignoring its ADX indicator (the black line).
Chart Analysis
The chart basically tells us that MDT price remains between -2% and +2% for several weeks, which seems to be a great confirmation for our trade. Of course, past performance cannot confirm future price changes, but you may be onto something here: this is a stock that does not move a lot on average when the ADX is low.
Visualizing Low-ADX Phases
As another piece of evidence, you may like the idea of actually visualizing the low-ADX phases on the historical stock price. The chart below helps with this: the gray areas correspond to those days in which the ADX indicator was below 20:
Note that there were phases in which the ADX remained low for many more days compared to the 10-day average mentioned above, while there were even days in which the ADX moving below 20 was just a touch-and-go.
Practical Considerations
- Likelihood of ADX Moving Above 20: Understanding how likely the ADX is to move above 20 in the short term is crucial. For instance, if MDT has an imminent earnings report coming, or if there’s an important announcement expected, the ADX might spike above 20, making the trade less favorable.
- Historical Context: Always consider the historical context. If the stock has had periods where the ADX stayed below 20 for longer than average, it might indicate a prolonged calm period, which is good for iron condors.
- Market Conditions: Check the broader market conditions. Even if MDT’s individual metrics look favorable, overall market volatility can impact the stock. Ensure the market environment supports your strategy.
Understanding the ADX Methodology (and Its Limitations)
The reason why the ADX indicator tends to be a good signal to spot when a stock is range-bound is because of the ADX methodology. The ADX indicator smooths out price movements, giving a more accurate representation of the trend.
The ADX measures both positive and negative directional movement. It takes the difference between the current high and the previous high, as well as the difference between the current low and the previous low, to determine how strong or weak a stock’s trend is. When this number rises above 20, traders typically tell themselves, “Hey, the stock is trending, so I will move on to a trend-following strategy.” Instead, when the indicator stays below 20, traders conclude that the stock is range-bound and may start looking for an iron condor trade.
However, the ADX methodology has its own limitations. Once again, consider that everything we told you today is purely statistical analysis: ADX gives you an estimate of what a stock might do, but it is not a certainty. The biggest limitation of the ADX methodology is that it only works until it does not. In other words, there will be times when the ADX indicator stays below 20 for 10 days, and then all of a sudden jumps up to 30 or more. This is why it is crucial not to solely rely on this indicator; instead, use it as one piece of your overall trading strategy.
Note that we spent almost no words analyzing the MDT company in our example above, but this is something that every trader should always do first, before even considering using any technical indicators. Do not become a slave of statistical tools but, rather, learn how to use them wisely in combination with your own judgment and experience.
Run Your Own Backtest
If you enjoyed the examples in our article and want to run your own backtests on various tickers, you can easily use our Google Colab notebook. Just make a copy and modify the parameters to your preference.
For quick access to all necessary resources, we’ve included a few links below:
