By trading along with a strong trend, you lower your risk and increase your profit potential. When a price is trending strongly, the average directional index (ADX) is used to determine its direction. This is a useful indicator in many cases. You may consider the trend as your friend, but if you know who your friends are, you will have a much better understanding of the trend. As part of our discussion of trend strength, we will explore the ADX as a trend strength indicator.
Trend strength is measured by ADX. Calculations of ADX are derived from a moving average of price expansion over a given time period. ADX can be used on any trading instrument such as stocks, mutual funds, exchange-traded funds, and futures. The default setting is 14 bars, but other periods can be selected. The ADX is shown as a single line with values ranging from 0 to 100. Indicator ADX is non-directional; it measures the strength of trends whether the price is moving up or down. ADX is typically plotted in the same window as the two directional movement indicator (DMI) lines from which it is derived. ADX measures the strength of an upward trend when the +DMI is above the -DMI. Prices are moving down when the -DMI exceeds the +DMI, and ADX measures the strength of the downtrend. ADX indicator is used to measure the overall strength of a trend. It stands for Average Directional Movement Index. The ADX stands for Average Directional Movement Index. Welles Wilder developed the Directional Movement System, which includes the ADX.
This system attempts to measure the strength of price movement in positive and negative direction using the DMI+ and DMI- indicators along with the ADX. Nowadays it has become one of the favorite indicators for technical analysts who study the historical price against time to analyze the supply and demand forces in the market.
“Trend is your friend” is a common belief of traders.
Once the trend is identified the next important thing is “timing”. The challenge is to determine the best time to enter and exit a trade. Using the DMI+ and DMI- indicators along with the ADX, this system attempts to measure the strength of price movement in both positive and negative directions.
ADX, which is a moving average of the Directional Movement Indicator (DMI), is composed of Positive Directional Indicator (+DI) & Negative Directional Indicator (-DI).DMI is used to identify a definable trend. The scale for the DMI ranges from 0 to 100. Any negative value in DMI is considered as zero.
Positive Directional Indicator (+DI):
When the Positive Directional Indicator crosses above the Negative Directional Indicator, analysts say the trend has begun.
The upward trend should be represented by an upward sloping curve.
Uptrends are stronger when the curve is steeper.
A positive DMI indicates an increasing distance between the current high and the prior high minus the current low.
In the calculation of ADX, it is a crucial factor.
Negative Directional Indicator (-DI)
The Negative Directional Indicator crosses above the Positive Directional Indicator to signify a downtrend.
For the downtrend, the curve should have an upward slope. Downtrends are stronger when the curve is steeper.
When the current low minus the prior low exceeds the current high minus the prior high, the DMI is negative (minus).
In the calculation of ADX, it is a crucial factor.
ADX, or Average Directional Index, is the average of the DX values in a given Period.
Average True Range (ATR)
The indicator was developed by Welles Wilder to measure the volatility of commodities.
Based only on highs and lows, a volatility formula would not capture volatility from gap and limit moves.
As a result, Wilder created ATR to capture the volatility that was missing.
Rather, it describes volatility rather than providing an indication of price direction.
The basic strategy
Chartists can identify the strongest and most profitable trends to trade by quantifying the trend strength. The lower the value, the greater the accumulation or distribution.
ADX below 25 for 30 bars or more on average indicates the price is entering a range and may consolidate.
The choppy movement provides an opportunity for a new trend to emerge.
As a result, the trend strength increases when the ADX line rises.
Chartists watch for the Positive Directional Indicator to cross above the Negative Directional Indicator to mark the beginning of an uptrend, whereas, to mark the beginning of a downtrend, they watch for the Negative Directional Indicator to cross above the Positive Directional Indicator.
An ADX falling below the zero line has the misperception that the trend will reverse.
The trend is weakening simply because its strength is waning.
The higher the ADX peak, the greater the trend momentum, while the lower the ADX peak, the smaller the trend momentum.
Divergence of momentum is also possible.
This suggests that price has made a higher high and ADX has made a lower high.
Divergences are not signs of reversal, just a warning that the trend momentum is changing. The trend may be continued, consolidated, corrected, or reversed.
In addition to identifying breakouts, ADX also helps to determine when breakouts are valid.
As soon as it crosses 25 from below, the trend is powerful enough to continue in the direction of the breakout.
Strategic use of ADX
One of the most important signals on a chart is the price. Observe what price is doing first, and then look at ADX in the light of what price is doing. A good indicator should be able to tell us something that the price alone cannot. A trend arising from a period of price range consolidation, for instance, often signals higher prices in the future. Typically, a breakout from a range occurs when there is a disagreement between buyers and sellers on price, which tips the balance of supply and demand in one direction or the other.
Whether there is more supply than demand or more demand than supply, price momentum is created by the difference. It’s easy to identify breakouts, but they rarely succeed or ultimately end up being a trap. Nevertheless, ADX lets you know when breakouts are valid by showing when ADX is strong enough for the price to trend after the breakout. The price is strong enough to continue in the direction of the breakout when ADX rises from below 25 to above 25.
Range finding with ADX
On the other hand, it can be difficult to identify when price moves into range conditions. An ADX indicator shows when the trend has weakened and the range is consolidating. An ADX drop from above 25 to below 25 signifies range conditions. A price range has a sideways trend, and buyers and sellers generally agree on the price. In the near future, the ADX will meander sideways under 25 until the balance between supply and demand changes again.
In combination with price, ADX provides great signals for strategy. Then choose the appropriate trading strategy for that situation based on ADX’s determination of whether prices are trending or not. Trending conditions result in pullback entries taking place in the direction of the trend. Range conditions do not lend themselves to trend-trading strategies. On the other hand, long and short trades can be made on reversals at support and resistance.
This indicator works as follows:
- When ADX is above 25, Wilder suggests a strong trend is present, and when ADX is below 20, there is no trend.
- A trend may be ending when the ADX turns down from a high value. If you are considering closing open positions, you may want to do more research.
- In a declining ADX, the market may be becoming less directional, and its current trend may be waning. As the trend changes, you may want to avoid trading trend systems.
- As long as the ADX rises by 4 or 5 units during this period (for example, from 15 to 20), it may provide a signal to trade the current trend.
- ADX indicates a strengthening trend when it rises. A trend’s slope determines the ADX value. As price movements accelerate (trend slope changes), the ADX line slopes upward. The ADX value tends to flatten out if the slope of the trend is constant.
The Trend Momentum
As well as representing overall trend momentum, ADX peaks provide a visual representation of it. An ADX peak clearly demonstrates whether a trend is gaining or losing momentum. Price velocity is the measure of momentum. The higher the ADX peak, the stronger the trend momentum. Decreasing trend momentum indicates a lower ADX peak. Even if the peak is lower, any ADX peak above 25 is considered to be strong. The price can still rise in an uptrend even when the ADX momentum is decreasing because overhead supply is depleted as the trend progresses. Trading with the knowledge that momentum is increasing gives the trader confidence to let profits run instead of exiting before the trend is over.
Nevertheless, a series of lower ADX peaks is a warning to watch price and manage risk. Objective signals are more important than emotions when deciding how to trade.
Momentum divergence can also be shown by ADX. There is negative divergence, or non-confirmation if ADX makes a higher high and price makes a lower high. Differencing is generally not a signal for a reversal, but rather a signal that trend momentum is changing. Taking partial profits or tightening the stop-loss may be appropriate.
At any time when a trend changes, risk needs to be assessed or managed. As a result of divergence, a trend can continue, consolidate, correct or reverse.
The strongest trends are the most profitable for a trader.
ADX assists chartists not only in identifying trending conditions but also in determining the strongest trend to trade.
Traders who are risk-averse can also use it to alert themselves to changes in trend momentum.
Although, at the end of the day, it is the chartist’s responsibility to stay ahead of the action by quantifying the strength of the trend.
In order to create better trading signals, ADX should be used in conjunction with other technical indicators and chart patterns.
Learning never ends so keep learning.