Average Directional Index (ADX)
The average directional index (ADX) is an indicator that is used to measure the strength of a current trend. Its associated indicators, +DI and -DI tell us the direction of the trend. The three lines together tell us: If a trend exists (ADX), and, the direction of the trend – up or down (+DI and -DI).
The ADX measures the strength of a trend but not the direction. The ADX is measured on a scale between zero and 100. Readings below 25 signal a weak trend while readings above 25 signal a strong trend.
Please remember that ADX is non-directional. When there is a strong uprend, the ADX will rise. When there is a strong downtrend, the ADX will rise. A rise in the ADX tells us that the market is trending, it does not tell us the direction.
The +DI measures the strength of the upward trend while the -DI measures the strength of the downward trend. These two measures are also plotted along with the ADX line.
Using the +DI and -DI
The +DI and -DI together tell us whether the bulls or the bears are in control. When the +DI line is above the -DI line, bulls are stronger. When the -DI line is above the +DI line, bears are stronger.
What the ADX does ?
1. It tells us when the trend is weak (use range trading tools, such as overbought / oversold indicators).
2. Tells when the trend is strong enough to trade with the trend (use trend following methods like moving averages, Alligator, MACD).
3. Allows us to see the strength of bulls & bears and determine who is in control.
4. Works in all time frames.
Basic Rule:
When ADX > 25
If +DMI is above –DMI, prices are trending up.
If –DMI is above +DMI, prices are trending down.
The actual trade may be taken on any one of the two triggers: (1.) When ADX crosses above 25, or, (2.) When +DMI crosses above -DMI and vice versa.
If ADX is less than 25 then either (a) avoid trading or (b) use range trading methods like RSI, Stochastics.
In Trend Mechanic, the ADX indicator provides the ability to plot three seperate lines:
1. ADX – this is the main plot. This indicator provides a measure of trend strength.
2. +DI – This line measures the strength of the bulls. the +DI line is used with the -DI line.
3. -DI – This line measures the strength of the bears. the -DI line is used with the +DI line.
Tips & Tricks
1. If you want to see only the ADX, then you can turn off the +DI and -DI plots by unchecking them.
2. You can change the value of the mid point line to quickly identify stocks meeting a specific requirement.
When the ADX starts rising and crosses 20, this is a sign that a new trend may be emerging. To quickly identify stocks where the ADX has moved above 20, you can change the value of the mid point line from the default of 25, to 20.
A strong trend is indicated when the ADX is above 30. To quickly identify such stocks, change the value of the mid point line from the default of 25, to 30.
A stock is trendless when it has an ADX below 15. Such stocks should not be in your trading list since there is negligible trend in their movement. But, if it is an active stock, then the ADX below 15 may signify a period of rest & contraction. Such stocks should be monitored for possible breakouts. To quickly identify such stocks, change the value of the mid point line from the default of 25, to 15. The ADX should be trading below the mid point line.
3. A Moving Average can be applied on the ADX to identify changes in ADX movement. Apply a 5 period Moving Average. The Moving Avearge option is at the lower end of the ADX indicator Window. Click on the checkbox to activate the Average. Change the average value from the default of 14, to 5. (For clarity, you may like to turn off the +DI an -DI lines).
When the ADX crosses above its average, an early warning signal comes in that the ADX may have started its up move. A rising ADX signifies a trend. When the ADX crosses below its average, an early warning signal comes in that the ADX may have started its down move. A falling ADX signifies that a trend is losing strength.
ADVANCED IDEAS
1. When the DMI lines move away from each other and the ADX is rising – there is a trend which can be traded. When the DMI lines move towards each other and the ADX is falling – trend is weakening.
2. Use 25 as the benchmark for the ADX.
When ADX falls below 25, price is usually in a consolidation period and trend trading strategies will normally fail. Once ADX rises above 25, the trader can use trend trading strategies.
3. Often, the best trades begin from low ADX periods.
When ADX is below 25 for an extended period, draw trendlines on price and wait for a breakout.
4. Traders should watch the direction of the ADX line. If the ADX line is moving up, then a trend is emerging. If the line is moving down, then the trend may be slowing down. Often, the direction of the ADX is more important than the level at which is stands.
[Example: We have two stocks, A & B. While the ADX for A is at 18, it has been rising from a low of 8, suggestng that a new trend may be emerging. The ADX for B is at 32, but it has been falling from a high of 45, suggesting that the trend may be ending. ]
