Average directional index (ADX) is used as a trend strength indicator that points out if the market is trending & how strong/weak it is.
Usually, ADX uses 14 day period. But you can implement it on an hourly or weekly chart also. Let us start with the definition.
What is an ADX Indicator?
Average directional index is a technical analysis tool that is used to measure the strength of a trend and its direction. In other words, it helps traders assess whether a stock is in a trending or ranging market to trade accordingly. Traders can then form strategies accordingly to make the best out of the information.
The average directional index is one of the technical indicators developed by Welles Wilder, the legendary American trader. Wilder has invented a number of technical indicators, including the relative strength index (RSI).
ADX indicator comes with three lines indicating the different data. Take a look at the picture below.
Here, the black line is the ADX line. Its value shows the strength of the trend. The higher the ADX value, the stronger the trend.
The green line is the Plus Directional Movement Index (+DM ). It is a positive directional indicator. It gauges the strength of the upwards price movements in the graph. The higher the price movement, the higher the +DM value.
The red line is the Negative Directional Movement Index (-DM). It is the negative directional indicator. Contrary to the above, the line measures the strength of downwards movements in the graph
Calculation of ADX
As you can see in the above picture, there are three lines that we need to calculate here – the ADX line, the +DM (positive directional indicator) and -DI (negative directional indicator). You can do the same by following the below steps.
First, the +DM and -DM and true range (TR) for each period have to be calculated. 14 is the default period used mostly. Here,
+DM = current high – previous high.
-DM = previous low – current low.
We use +DM when the difference between the current high and the previous high is greater than the difference between the previous low and the current low. We use -DM when the difference between the previous low and the current low is greater than the difference between the current high and the previous high. TR is the bigger number among the current high – current low, current high – previous close, or current low – previous close.
Once those are found, you can use the below equation –
+DM =(Average true range Smoothed +DM)× 100
-DM =(Average true range Smoothed -DM)×100
DX=(∣+DI+-DI∣∣+DI−-DI∣)×100
ADX= 14(Prior ADX×13)+Current ADX
Although the calculation may look complex, the idea behind the lines is straightforward – the ADX line shows the strength of the current price. In contrast, the other two lines act as positive and negative directional indicators.
Reading the ADX Indicator
ADX is a trend strength indicator, and the primary reading the ADX indicator gives is about how strong a particular trend is and whether a stock is in trending or ranging markets. But that information is given by the ADX line alone. Then, how can we make use of the other two lines? Let us examine the signals given by each of the three lines.
The ADX line
In the picture, the above is the price graph and below is the ADX indicator. The black line is the ADX line here. As we have discussed above, the higher the number the ADX shows, the higher the strength of the trend. If the ADX value is below 25, it shows an absent or weak trend. It is safe to assume that such a market is ranging.
If ADR shows values between 25 and 50, the market is considered to have a strong trend. This is usually a good place to utilise the trend strength to make a profit.
On occasions, the ADR line can go above the 50-level mark as well. A reading between 50 and 75 shows an extremely strong trend. Rarely the ADX can go even beyond 75. Such a reading shows the maximum possible trend strength, and it also slightly hints about hitting the threshold and a possible trend reversal in the future.
Now, in the picture above, you can see a generally trending market, with the price in the positive territory. The same can be confirmed by the ADX readings from below, where the line consistently stays above the 25-level mark. Here, by looking at the ADX line, you can confidently enter and stay in a trade to make use of the uptrend.
But a common mistake traders make they compare the price change with the ADX line. In the above picture, the ADX line mimics the price graph. But that doesn’t mean the price necessarily comes down when the ADX line comes down. If the price is in a downtrend and the trend is strong, the ADX will still be up. Take a look at the picture below.
This is a recent price and ADX chart of Zomato. Here, you can see that the price is generally in negative territory. The ADX line gauges the strength of the downtrend in this occasion.
The ADX values stay over 25 on most occasions, and it even breaches the 50-level towards the end. This shows an extreme downtrend. After confirming with other technical indicators, you could enter a short position to ride along with the trend here.
Positive directional indicator
The positive directional indicator gauges the strength of an uptrend at any given point. It looks for green candles in the graph and reads a higher value when there are more green candles. For instance, take a look at the picture below.
This is a 5-minutes chart of ONGC on a particular day. Here, take a look at the area marked by the cross-hair. You can see that as soon as the price starts to rise, the positive directional indicator starts to go up as well.
Negative directional indicator
Let us look at the same picture once more. Here, the red line is the negative directional indicator. You can see that it mirrors the green line but in the opposite direction, showing the strength of the downtrend.
ADX trading signals and strategies
The positive and negative directional indicators need not produce any signal on their own. Instead, the movement and crossover of the lines with the other lines in the indicator produces a signal. Let us see how those signals can be understood and how we can form a strategy from those.
Bullish crossover
As said above, the crossover of the directional movement indicators could give you a trading signal. It could give you both a buy and a sell signal. Let us explore the bullish signal crossover first.
Both the trend direction indicator lines gauge the strength of the price change in either direction. So when the positive directional indicator line crosses above the negative directional indicator line, it shows that the rate of positive price change for that stock is greater than the rate of negative price change. If the same happens when the market is above 25 (trending) or if there are higher ADX peaks, it could be considered a solid buy signal. Take a look at the below picture.
Here, pay attention to the area where the green line crosses above the red line. At that point, ADX is clearly above the 25-level mark as well, showing that there is a strong trend. This is considered a buy signal. If you look at the chart, you can see that the price goes up after the signal. Here, you could either buy the stock or enter a long position according to your strategy.
Bearish crossover
A bearish crossover is the opposite of a bullish crossover. This happens when the negative directional indicator line cross over the positive directional indicator line. This indicates that the negative price change is higher than the positive price change. Here, too, checking if the market is trending (ADX above 25) is important. It if is trending, then it is a sell signal. Let us understand this better with an example.
In the above graph, you can see the price going down once the red line crosses the green line. The ADX line confirms it is a trending market as well. Hence, this is a point where you can place sell orders or enter a short position, according to your plan.
Ranging market strategy
When the ADX is below 25, it is considered a ranging market. Here, there will be no solid trend. This information can also be used to formulate a strategy.
Usually, when there is no trend affecting the price movements, the price tends to obey the support and resistance levels. A trend is needed as a catalyst to break these levels. So, in the absence of such a trend, you can trust support and resistance levels to formulate your strategy. For instance, look at the below picture.
Here, at the beginning of the graph, the ADX was slightly above 25, and you can see the price breaking the central pivot point. But when the ADX slips below 25, the trend weakens, and the price tends to stick around the pivot point line. You can use this information to place orders when the price is near the central or any other pivot points.
Validating breakouts
A market won’t stay ranging for long, and it will eventually breakout. Such breakouts are often beneficial if you make the right move.
But the ADX indicator can’t give you a signal regarding breakouts. Here, you will have to use another momentum indicator, and ADX can act as the breakout confirming tool. The idea here is simple, whenever another indicator gives you the breakout signal, you can cross-check the same with ADX, and if the ADX value is 25 or reaches 25 from below, it shows a transition to a trending market from a ranging market.
ADX with other indicators
Since ADX is calculated based on the moving average, there can be a lag, often making it a weak indicator without a confirmation tool. But you can from a strategy combing ADX and another suitable indicator to give you much more trustworthy signals.
ADX with RSI
RSI is a momentum indicator that shows overbought and oversold levels. A reading above 80 is considered overbought, whereas below 20 is oversold in RSI.
Usually, when a stock hits its overbought or oversold threshold, it tends to bounce back. Overbought stocks’ prices tend to drop, and oversold stocks start to go up. If a price continues its direction even after hitting such a threshold, it may be in a highly trending market. Here, you can confirm the trend strength with the ADX indicator before making your move.
For instance, if a stock hits 80 or 20 in RSI and the ADX level is below 25, showing a ranging market, the chances of the price bouncing back become higher.
Bottomline
ADX, coupled with its directional movement system, is often your best bet in gauging trend momentum. While ADX, being a lagging indicator, may show weakness when used as a standalone tool, it could give more accurate readings and help your strategy when used alongside other suitable indicators.
FAQs
What does it mean when the ADX rises and falls?
The ADX is a measure of the current trend’s strength. So, when the ADX rises, it means that the strength is getting stronger. Usually, an ADX value of over 25 indicates a trending market. Some of the strongest trends may even make ADX values go up above 75.
Can we gauge trend continuation using ADX?
The ADX may stay above the range of 25 as long as a trend continues. A declining ADX value could be an indication of a trend slowing down. But understand that ADX value will go up for trends in both the direction.
