The trend is an important feature of trading that traders use to help them read the market movement better, so they can execute their trading strategies at the perfect moment.
Trend strength simply refers to the level of influence buyers or sellers have over the market over a particular time.
In a weak downtrend, the trend may be bearish, but it still experiences great upward pressure. But in a strong downtrend, the trend is completely bearish, and the bulls usually watch from afar.
This article will highlight the Average Directional Index (ADX), which is an important indicator that is used to measure trend strength.
We’ll discuss what this indicator does, how it is calculated, and what traders use it for.
What is the average directional index?
The Average Directional Index, or ADX, is an indicator that is used to measure the overall strength of a trend.
It was developed by an American engineer named Wells Wilder and featured in his 1978 book New Concepts in Technical Trading Systems. In the book, he also talks about the relative strength index (RSI), parabolic SAR, and the average true range (ATR).
And though Wilder developed the ADX and his other technical analysis indicators before the digital age, they are still very popular today.
How this indicator works
The ADX is an important trend indicator that helps traders assess the strength of the underlying market trend. This indicator consists of the following three lines:
- The positive directional indicator (+DI),
- The negative directional indicator (-DI), and
- The ADX line.
What the lines tell you
If the +DI line is above the -DI line, this indicates that prices are on an uptrend, with the ADX line measuring the uptrend’s strength.
If the -DI is above the +DI, this shows that prices are on a downtrend. The ADX line measures the strength of this downtrend.
If the ADX line is above 25, this indicates that a strong trend is present. If the ADX line is below 20, it means that no trend is present.
When the ADX begins to drop from its high values, it indicates the end of an uptrend or downtrend. When the ADX line starts to go up, this signals that a trend is strengthening.
These guidelines can be simplified as follows:
- Below 25: weak trend, or range-bound
- Between 25 and 50: strong trend
- Between 50 and 75: very strong trend
- Between 75 and 100: extremely strong trend
Calculation
While the ADX indicator looks quite complicated when written as a formula, its calculation is quite straightforward.
The ADX line represents a smoothed moving average of the absolute values of the +DI and -DI, and its value oscillates between 0 and 100.
To calculate ADX, you need to first calculate the +DI, -DI, and true range for the period. In most cases, the ADX indicator uses 14 periods as a benchmark, but you can try out different periods.
It’s best to make use of trading software to calculate these values and then smooth them into a simple graphic format with three lines.
Trading with the ADX indicator
The Average Directional Index indicator can help traders to identify profitable points to exit a trade. It is available on almost every charting software out there.
When the ADX line climbs above 40 and is then followed by a downturn, this implies that the current trend is about to come to an imminent end.
Using this rule, when the line jumps above 40 and then makes a downturn, a trader should take their profit and exit. It does not matter if the trend is up or down. As soon as the line turns down, that is a sign to exit.
While the ADX can indicate the current trend, a reversal in the trendline shouldn’t necessarily be the next move. Prices may instead enter a consolidation phase and drift sideways for a while.
The ADX is not a useful indicator when prices are moving sideways. An ADX line may drop below 20 and even get closer to 10 during a prolonged consolidation period. When the line approaches 10, a significant move is usually about to happen.
Unfortunately, the ADX is non-directional which means that it can only tell you if the trend is gaining or losing momentum. It won’t indicate the probable direction of the move. Therefore, you have to use other technical analysis indicators to know which direction the move will go.
Traders can also use the ADX as a filter to help eliminate erroneous signals. Charts can include oversold or overbought positions for a long time period, especially during a strong trending market. So, to avoid entering or exiting a trade too soon, traders usually look at the ADX indicator.
They will stay with their positions provided that the ADX is going up. This indicator usually acts as a filter to weed off false countertrend signals.
Always keep in mind that the indicator isn’t going to tell you when to make a move in the opposite direction or jump back into the market. You will need to use other indicators to do that.
Limitations of the ADX
The ADX is popular among traders and technical analysts but it’s not a flawless indicator.
Here are two limitations traders you are likely to encounter when using ADX:
- ADX isn’t always helpful, since it lacks clear guidance regarding signals to use when getting out of a position
- It is a lagging indicator, meaning traders are always relying on past data to understand possible price movement.
Bottom Line
“The trend is your friend” is a popular expression among traders. Trends are extremely important to any trading strategy and the ADX indicator can help you identify the strength of various trends so you can follow them.
This indicator can be an essential part of your trading strategy, helping you identify points to get in and out of a trade, and providing analytical insight.
It is one of the most used technical analysis indicators because it is not only simple to use but can also be combined with many other indicators to create a variety of trading strategies.