In our recent blogs, we have been talking about how the indices or PSUs etc may showcase a trend reversal with the slightest provocation as there were weakish signs of bottoming out using the Bollinger Bands theories. There was another indicator which showed that whiile the Nifty 200 DMA was broken, there was no urgency to rush to 9200 levels as many think and markets were searching for an unknown direction!
This important indicator measures the strength of a trend – the ADX – and is vital for traders to know as it captures a lot of information inside a simple number!
The Average Directional Movement Index (ADX) was developed by famed technical analyst Welles Wilder as an indicator of trend strength. Wilder developed the indicator for trading commodity futures. but has since been widely applied by technical analysts to virtually every other tradeable investment, from stocks to commodities.
It is clear that Wilder was attempting to do two things with the ADX indicator:
- inform a trader when the market is trending so you don’t get caught in false breakouts
- filter out counter trend trades to keep you on the right side of the market so you know when its time to be on the sidelines
What is the ADX?
The average directional movement index is calculated to reflect the expansion, or contraction, of the price range of a security over a period of time. The traditional setting for the ADX indicator is 14 time periods, but analysts have commonly used the ADX with settings as low as 7 or as high as 30. Lower settings will make the average directional index respond more quickly to price movement but tend to generate more false signals. Higher settings will minimize false signals but make the average directional index a more lagging indicator.
Components of ADX
Wilder calculated the average directional index by first calculating both a positive directional movement index (+DMI) and a negative directional movement index (-DMI) that compare current high and low prices to the previous time period’s high and low prices. The ADX itself is then calculated as the sum of the differences between +DMI and –DMI over a given time period.
All the necessary calculations are a bit complex. Fortunately, there’s no need to do them yourself as most charting tools carry this facility including on the PL Mobile App . All you have to do is apply the average directional index indicator to a chart, with all the necessary calculations done for you, according to whatever time frame you choose.
The value of the ADX is proportional to the slope of the trend. The slope of the ADX line is proportional to the acceleration of the price movement (changing trend slope). If the trend is a constant slope then the ADX value tends to flatten out.
Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below 20. When the ADX turns down from high values, then the trend may be ending.
If the ADX is declining, it could be an indication that the market is becoming less directional, and the current trend is weakening.
If after staying low for a lengthy time, the ADX rises by 4 or 5 units, (for example, from 15 to 20), it may be giving a signal to trade the current trend. If the ADX is rising then the market is showing a strengthening trend.
ADX indicator Scale
An ADX line is plotted between 0 to 1oo.
|ADX Value||Trend Strength|
|0 – 25||Absent or Weak Trend|
|25 – 50||Strong Trend|
|50 – 75||Very Strong Trend|
|75 – 100||Extremely Strong Trend|
Identifying Trend Changes
A weakening trend is signaled when 14-day ADX turns down while above 40. Note that ADX only indicates trend strength — not trend direction. It may be wise to supplement ADX with a trend filter, whether directional movement or a moving average, to signal direction.
ADX Readings on Nifty
One can see how the trends reversed on the Nifty once ADX started declining , how rises/declines accelerate when it rises, and how in recent days ADX has been non trending – leading to consolidation moves.
However, the indicator only presents a trend strength and not the direction itself so one needs to combine it with other indicators. It is not a good idea to use rising or falling ADX as indicators to buy or sell assets.
Using ADX for trading strategy
The ADX can be used to make short term profits by trading in the direction of strong trends.
Analysts and investors rarely use the average directional index indicator alone. Since it does not indicate trend direction, it is commonly used in conjunction with trend indicators, such as moving averages or support and resistance areas, which are used to analyze price movement.
One could combine indicators to come out with a multitude of strategies like for example, one is given below:
Momentum Indicator with ADX
- Go short when ADX rises above 20 and Momentum is below zero.
- ADX down-turn above 40 warns that the trend is weakening.
- Exit when Momentum crosses above zero.
- ADX holding below 20 indicates a ranging market.
- Go long when ADX rises above 20 and Momentum is above zero.
- Increase position when ADX recovers above 20 and Momentum still above zero.
- Exit when Momentum crosses below zero.
The MACD-ADX Combination
The MACD is going to detect the trend reversals, while the ADX is showing either the trend is strong or fading.
Example, a buy signal could be as follows
- Buy when MACD rises above zero.To confirm the signal D+ line of the ADX indicator higher the D- line.
- ADX line is above 20 and rising upwards.
- On the candlestick where these three conditions are met, you make a Buy.
- Do the opposite for sell entry rules.
Price Channels/ Levels and ADX
One application of trend indicators in combination with the ADX would be , for instance, a situation where the price of a security has traded within a range and then breaks out by trading through a support or resistance level.
If the price breakout is accompanied by rising ADX readings, that would constitute a confirmation of the validity of the breakout, and an analyst would project a trend continuing in the direction of the breakout.
ADX as a Divergence Indicator
The ADX is also sometimes used, as other momentum indicators are, as a divergence indicator that can signal an impending trend change or market reversal.
ADX values will rise to increasingly high levels along with price in a market that is trending strongly higher.
But if ADX levels begin to decline even as price rises higher, this divergence between price movement and the ADX may signal that the market is losing momentum and therefore may be due for a turn to the downside.
The DI crossover signal
When the DI lines cross each other, they give a signal. The green line crosses above the red line, it means that the highs and lows of the previous candles are both moving higher which confirms an uptrend.
When the red DI line crosses above the green DI line, it shows that over the past candles, price has been moving down and the lows and highs are going lower.
Before You Trade
The Average Directional Movement Index is a versatile technical indicator that can be used as a stand-alone trading strategy, or in combination with other trading strategies.
As the ADX measures the strength of the underlying trend, trend-following traders can use it to filter flat and ranging markets and avoid trading during those times.
One could ideally combine ADX with other indicators to reduce false signals or to enter only select trades.
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