I once knew a person who was new to trading but was passionate and disciplined. He spent countless hours learning to read chart, spot trends and other nitty gritty of technical analysis.
One afternoon, he shared a chart of a well-known tech company that was breaking out of a consolidation pattern. The price has just moved above MA, RSI showing momentum rising and a bullish engulfing candle has formed. The confluence of indicators made him super excited to buy the stock. However, I advised him otherwise. I advised him to wait for a few sessions for confirmation.
But being confident, he entered the stock and risked more than he risks usually. He placed his stop-loss and waited for the smooth rally to commence and profits to accrue. However, the markets had other plans.
Instead of rising, the stock dipped and dipped more and before he knew what went wrong, the stock hit his stop-loss forcing him out of market. The breakout was a fake out. He contacted me once again, discussing the failed trade and to enquire why I asked him to wait.
Then I revealed that the said stock had ADX at 14, suggesting that there was little strength in the movement and that the stock was still range bound.
Trend direction is important, but trend strength is equally important in deciding for or against a trade. This is the lesson that many traders (including me) learn hard way after a few losses and this is where ADX comes to our rescue. By measuring strength of the trend, ADX saves us from many losing trades. In this post, we are going to learn about this indicator in detail.
What is the Average Directional Indicator (ADX) indicator?
In trading, identifying trend direction is important, but knowing the strength of trend is as important.
Developed by J.Welles Wilder, ADX helps traders determine whether a stock is trending and how strong that trend is. It is important to mention here that ADX only measures trend strength and doesn't tell us about the trend direction. It doesn't differentiate between an uptrend and downtrend.
For example, an ADX value of 35 will tell us that the trend is strong but it will not tell us whether it is a strong uptrend or a strong downtrend. To know the trend direction, you have to use ADX along with other indicator like RSI or Moving Average or directional movement indicators.
How is ADX Calculated?
Though calculation of ADX is beyond this article's scope, however, I would like to give a basic idea about the calculation of ADX in brief.
ADX is derived from values of two other indicators called as Positive Directional Index(+DI) and Negative Directional Index(-DI).
+DI and -DI values are used to calculate Directional movement index (DX).
The values of DX is then averaged over a specified period to arrive at values of ADX. The default period for ADX is 14, however, you can adjust it to any number based on your trading style.
Most of the charting software these days calculate ADX values automatically, so, you don't need to go deep into the calculations unless you are researching on the topic.
How to interpret the ADX indicator?
In a chart ADX is plotted below the price chart as a continuous line that varies between 0 to 100. Many charting software packages plot the +DI and -DI lines, along with the ADX line, simplifying the identification of both trend strength and direction in a single window. Let's take a look at a chart to better understand this.
In the above chart you can see ADX indicator plotted below the price chart with +DI and -DI. The blue line in the chart is ADX while green and red lines are +DI and-DI respectively.
While the ADX line depicts the strength of the trend the relation of +DI with -DI depicts the direction of trend. +DI above -DI suggests an uptrend while +DI below -DI indicates a downtrend.
Based on this preliminary knowledge, let's now know how to interpret the ADX indicator.
ADX below 25 -------- No trend or weak trend
ADX between 25-50 -------- Strong Trend
ADX above 50 -------- Very Strong trend
To know the trend strength and direction both look at +DI and -DI as well apart from ADX.
ADX > 25 and +DI > -DI ------- Strong uptrend
ADX > 25 and +DI < - DI ------- Strong downtrend
Let's see this in a couple of charts-
In this daily chart of TATAMOTORS you would see the ADX to be above 25 at the point marked by an arrow, suggesting a strong trend. Further +DI > -DI at that same point suggests the stock is in uptrend. So, the stock is in strong uptrend.
In this daily chart of TATAMOTORS ADX has been shown to be above 25 by an arrow, suggesting a strong trend. Further, +DI less than -DI suggests the trend is a downtrend, thus, the trend in above chart is a strong downtrend (at the point marked by an arrow).
How to use Average Directional Index (ADX)?
In the previous section we learnt how the ADX indicator can be used to measure the trend strength and combined with +DI and -DI, it also gives the trend direction. But question here is how to put this knowledge in practical conditions when you are trading. Well, this is what you are going to learn in the paragraphs that follow.
Here is a list of number of ways you can use ADX to make trading decisions.
1) To avoid choppy market conditions- It is always advisable to trade in direction of trend and to avoid weaker or range bound markets. A range bound market is called a choppy market as there are greater chances of a losing trade in such conditions.
ADX below 25 would tell you that the market is choppy and that you shouldn't be entering the trade in such conditions.
2) Using +DI and - DI crossovers- Directional movement indicators, +DI and -DI crossovers signal buy and sell signals and coupled with ADX they can be used to get entry and exit signals.
+DI crossing above - DI with ADX above 25 is a buy signal while -DI crossing above +DI with with ADX above 25 is a sell signal.
Take a look at these signals and how they work with the help of a chart.
For example, a moving average crossover, where a faster moving average crosses above a slow moving average is a buy signal. But this crossovers frequently gives false buy signals and leads to losses. These false signals can be filtered out by using ADX in addition to moving averages.
Let's see this in a chart.
The chart above shows a number of false buy and sell signals validated through ADX.
The chart above shows a valid buy signal. See that as 50 MA crosses above 200MA, the ADX is above 25 indicating that the buy signal is valid.
ADX can be used with other indicators to make some profitable trading strategies, however, this would be beyond the scope of this article. I wanted to give a very basic idea about ADx in this article. The detailed strategies using this indicator will be discussed in some other article.
So, this is all for now. See you all in other article soon!
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