ADX: How To Interpret The Trend Strength Indicator
Trading in the direction of a trend reduces risk. Identifying a strong trend in the market is the prerequisite of a successful trade. It is a skill that every trader should have. But, how to determine if the trend is strong or weak? A strong trend is worth following as it increases the chances of profit, but when the trend is weak, it would also lead to potential loss.
ADX or average directional index is the ultimate trend indicator that will help you decide if a trend is worth following or not. Average directional index, minus directional index (-DI), and plus directional index (+DI) form a cluster of indicators that help you deduce both direction and strength of a trend.
Why Do You Need A Trend Strength Indicator?
While planning a trade, you need to identify if the underlying is in trend or not. But stocks prices spend more time in consolidation than trending, resulting in multiple drawdowns. With the help of ADX, you can quantify the strength of a trend.
ADX is computed based on moving average of price over a period. It is plotted as a line, on a range between zero and hundred. It was conceived by Welles Wilder Jr., who designed it to measure the directional movement of commodities and price, but ADX is now widely used for stocks as well.
In Wilder’s Directional Movement System, the two, plus directional indicator and minus directional indicator form the basis of the theory. He formulated trend direction by measuring the difference between two consecutive lows concerning their highs. The plus directional and minus directional indicators, together called Directional Movement Indicators (DMIs), are derived from a smoothed average of differences measured over a period. The ADX indicator is calculated from the smoothed average of the differences between +DI and -DI. While DIs measure the direction of the trend, ADX measures the strength of the trend. The default setting for ADX is 14 bar but can be adjusted for other time periods also. ADX is non-directional, and together, the DIs and ADX measure both direction and strength of a trend.
How Are Directional Indicators Calculated?
In a trend, price movement isn’t steady. There are intermittent periods of drawdowns, even when the price is rising. Directional movement is a method of comparing two consecutive lows with their respective heights. This comparison helps to measure if DI is positive or negative.
When the difference between the current high minus prior high is greater in value than the difference between prior low and current low, the DI is positive. The DI is positive if the difference between the current high and prior high is positive. If it is negative, the value is entered as zero.
Conversely, the DI is negative when the difference between the historical low and current low is higher in value than the difference between the current high and prior high. For negative or minus DI, the difference between previous low and current low must be positive. If it is negative, the value is entered as zero.
These DI points plotted in a trading chart against each other form a DI line. When the +DI lies above the -DI, the price is moving upward. When the negative DI is above the plus DI, the price is moving downward. ADX is then applied to measure the strength of the trend.
You can notice that in both cases, when the +DI rises above the -DI and conversely, when the -DI rises above +DI, the ADX moves up, indicating the strength of the trend.
Calculating The ADX Indicator
Average directional index determines the strength of a trend. However, it doesn’t indicate if the trend is bullish or bearish like other popular indicators, such as RSI. ADX achieves the following,
- Showing the trader when the market is trending
- Filters the anti-trend moves to help traders chase the trend
- Allows traders to identify the most profitable trend
- The value of ADX helps in determining between trending and non-trending conditions or when the price enters a range
- It enables traders to apply trend trading strategy when the trend is strong as against when the trend is moving sideways
ADX is the smoothed average of the Positive Directional Indicator and Negative Directional Indicator and doesn’t have a negative value.
Here is a chart showing ranges of ADX against the interpretation associated with those
|An absent or weak trend
|Extremely strong trend
Many traders consider ADX value above 25 is a strong trend to follow. ADX below 25 is the moment of accumulation or distribution. When ADX stays below 25 for 30 bars, the price usually enters a range and oscillates between support and resistance levels to find selling or buying interests. After the low period, the price will break into a trend.
Correctly interpreting ADX is a critical part of technical trading. While studying ADX, you must keep in mind that ADX doesn’t indicate a trend reversal. It merely determines whether the trend is strong enough or not. Often falling ADX is misinterpreted as an indication of a trend reversal. But falling ADX is a mere indication that the current trend is losing steam. You can apply the simple rule of thumb to deduce ADX.
- ADX below 25 signifies a weak trend
- When ADX above 25 and rising, the trend is strong and rising
- When ADX is above 25 and falling, it means that the trend is weakening
Interpreting Trend Momentum With ADX
Using ADX peaks, traders can determine when the trend momentum is strong. Higher ADX peaks indicate the price momentum is robust, and when the peaks are low, it suggests that the momentum is weakening.
- An ADX over 25 indicates a strong trend, even if the peaks are low
- In an uptrend even when ADX is falling the price can still rise because overhead supply gets eaten up as the trend progresses
- A falling ADX, when the price is rising, signifies that the trend is losing momentum, but the uptrend continues
- ADX creates a momentum divergence when the price attains higher high, but ADX reaches a lower high. It creates a negative divergence
- Negative divergence is an indication that trend momentum is changing and a phase of non-confirmation has occurred
Contrary to when divergence occurs, when trend momentum is rising, it gives traders the confidence to let their profit run without exiting the trade. Conversely, ADX divergence indicates when the momentum is falling so that a stricter stop-loss can be applied.
Using ADX For Trading Strategy
ADX helps traders to determine when a breakout is strong enough to trend. Breakouts are moments in the price chart when there is a disagreement between the buyers and the seller, resulting in a trend reversal. However, breakouts often fail to progress and end up being a trap. ADX tells you when a breakout is strong enough to trend. When ADX rises above 25, it is a strong trend to follow.
ADX indicators are also helpful as a range finder. When ADX slips from above 25 to below 25 range, it indicates a weak trend. In this range, the trend is moving sideways. The ADX will remain at this level until the supply-demand equilibrium shifts again.
ADX can help you derive a winning trading strategy when combined with the price. It helps you pinpoint when the price is trending, and accordingly, you can form a strategy in the direction of the trend. When the price is trending, the pullbacks are used as the entry points.
Limitations of ADX
Although a powerful indicator, ADX also has a few flaws that you need to keep in mind.
1. Extraordinarily volatile and slow-moving stocks wouldn’t adhere to ADX indications
2. ADX is based on moving average, which is a laggard indicator, meaning ADX is also very slow
3. +DI and -DI crossovers happen very frequently giving false signals
4. ADX is used in association with other indicators and oscillators
Trading in the direction of the trend forms the basis of technical trading. Traders use a vast number of trading charts, indicators, and patterns to understand trend direction, but none of these is helpful if you need to understand the strength of the trend. ADX indicator fills up the gap by quantifying trend strength. Moreover, it helps you find when the price enters a range so that you don’t waste time trying to trend trade. Also, you can use it for riks management as ADX indicator signals when momentum is slowing. If you want to become successful with trend trading, you can’t avoid ADX.