4.32 Using Average Directional Index (ADX) to Know Trend Strength
The Average Directional Index (or, ADX) is an oscillator used to indicate the strength or weakness of a trend.
You may find it confusing but though the name of the indicator contains “Directional Index”, standalone this indicator oscillator offers no clue as to the direction of the current move and will indicate only whether it is gaining or losing strength. The ADX is useful in judging if the market is moving sideways (having no trend) or is entering a fresh trend. However ADX comes in a package of three components, the ADX line itself and two other lines known as "Positive Directional Index" (+DI) and "Negative Directional Index" (-DI). These two additional components complement ADX by defining the direction of the trend.
Let’s first get to know the working of this indicator before getting down to the construction aspects. Please note that as a trader you do not really have to worry about the specifics of it’s construction and all the complicated formulas.
As the ADX is not any easy oscillator to study visually, we thought we’ll tell you the levels and what they mean. So here’s the ADX cheat sheet!
- Extreme values = 0 to 100.
- ADX between 20 and 40 = Guideposts to the strength of the trend. In fact many trades consider 25 as the threshold for considering that a trend exists. This key level was also suggested by J. Welles Wilder, who had developed this indicator.
- ADX less than 20 = Current trend is weak or there is no trend at all.
- ADX above 20 and below 40 = A trend is emerging and trading should employ trend-following techniques
- ADX at 40 = The market is probably overbought or oversold and one should move to place stops to protect profits.
- ADX past 40 = Start booking profits.
Please note that during very strong trends ADX can shoot up well above 40 but caution is required as a reversal may be around the corner.
As mentioned above, the ADX only measures the strength of the trend without defining whether it is an uptrend or a downtrend. The direction identification is done by the +DI and -DI components as follows:
- Uptrend: An uptrend is indicated when ADX is above 25 and the +DI line stays over -DI line.
- Downtrend: A downtrend is indicated when ADX is above 25 and the +DI line stays below -DI line.
Let’s see the above levels in actual practice. Here’s an example of the ADX moving up from 25 levels and indicating a strong uptrend.
The above Forex chart speaks for itself and you will see how the ADX rose above 25 and went toward the range of 60 after breaking out of the rectangle pattern, when the price-action was in sideways more.
Please note that at times a strong reversal (in this case a downtrend) may take place immediately after the previous trend. In such case we cannot expect ADX to be above 25 to indicate the strength of the current trend immediately. ADX will drop down to indicate the weakening of the previous trend first and then rise up again to indicate the strength of the new trend. You will find an example of this later.
The following chart is an example of the ADX moving up from 25 levels and indicating a strong downtrend.
Notice that the ADX is pointing up in both the above cases. That’s because it’s not concerned with the direction of the price, only with the strength of its move up or down.
Let's see the next example when ADX in a ranging or sideways market:
See how the ADX lies low below 25 when the market is range-bound and remains there.
Charts can speak more than the words and hence it is always better to let them speak for themselves. Here's an example of ADX when the downtrend ended and price-action fell into sideways moves.
Times when you cannot rely on ADX
Yes, there are times when you should not look at ADX to check the strength of a trend or whether a trend is really existing. This happens when an immediate reversal of a trend takes place. In such case the ADX will fall below 25 to indicate that the ongoing trend has ended but would fail to indicate that the new trend is already in place and is strong. Well, give ADX a bit of time to bounce back. Check the following chart as an example:
How to trade with ADX
ADX can be used for trading in the following ways:
- Use ADX to know the strength of the trend and use other trend-following tools such as moving average, MACD and Parabolic SAR for entry and exit.
- Take a position in the direction of the trend when ADX moves over 20/25 range.
- Use +DI and –DI crossovers for entry and exit.
- ADX Divergences.
ADX Crossover Signals
The crossover signals for market entry and exit are generated by the +DI and -DI lines' crossover.
- +DI line moving upwards: When +DI line moves over -DI line, it indicates bullish sentiments and gives an signal for buying or exiting any short position which you might be holding.
- +DI line moving downwards: When +DI line moves below -DI line, it indicates bearish sentiments and gives a signal for short-selling or to exit any existing long position.
ADX trading signals are also generated or by divergences.
When the subsequent highs and lows (peaks and valleys) of ADX line are going lower than the previous highs and lows, it indicates an existing or emerging downtrend and signals an entry for a short-selling position. Similarly if the subsequent highs and lows are going higher than the previous ones, it is an indication that an uptrend is in place or is emerging and you can go for a long position.
It is always better to consult ADX on longer time-frame charts say before taking a decision on shorter time-frame charts. Longer time-frame charts give us a broader picture of the longer term trend. In simple words the short term chart may indicate that the trend is weakening but a longer term chart may indicate that the drop is just a temporary correction and the trend still exists.
Period Settings for ADX
The common period setting for the ADX is 14 periods. On a daily chart 14 period translates into 14 days and on a 4-hourly chart it means previous 14 candles of 4-hours price action.
- Average Directional Index (ADX)