Wouldn’t it be nice if you could tell the strength of an ongoing trend for a certain stock to improve your trading strategy? Well, I’ve got some good news for you — there is a way to do that! Let me tell you all about the ADX Indicator.
What is ADX?
The Average Directional Index (ADX) is a technical indicator that allows traders and investors to analyze and confirm the quality of a security’s trend in the financial markets. The indicator was developed by J. Welles Wilder, who also developed the Relative Strength Index or RSI and the Bollinger Bands®. ADX measures the strength of a trend regardless of its direction. This helps traders gauge the potential for price movements. Now let’s shed some light on its practical applications and limitations.
How is the ADX indicator calculated?
ADX follows a series of formulas to get the value. You can follow the steps below to calculate the values.
- First, calculate the positive and negative directional movement of the security. The look-back period commonly used by traders is 14. The directional movements take the difference between current and previous highs/lows and use the formula below:
+DM = Current High – Previous High
-DM = Previous Low – Current Low
- Then the average true range of the same period is calculated. You can calculate the 14-period directional index values (+DI and -DI) from here. Simply calculate the exponential moving average of the +DI and -DI using the same 14-period look back, then divide it by the 14-period ATR and multiply by 100.
14 period +DI = 100 x [EMA14 (+DM)/ ATR14]
14 period -DI = 100 x [EMA14 (-DM)/ ATR14]
- The next step is to use the 14-period +/-DIs to get the 14-period to get the Directional Index or DX by dividing the difference of +DI14 and -DI14 by the sum of +DI14 and -DI14 and multiplying to 100. You can express this into:
DX = [((+DI 14) – (-DI 14))/((+DI 14) + (-DI 14))] x 100
- The final step is to calculate ADX using the previous values we’ve derived. You will need to multiply the previous 14-period DX value by 13, then add the 14-period DX, divide it by 14, and multiply by 100. This can be expressed as:
ADX 14 = (((14 period DX x 13) + 14 period DI)/14) x 100
Seems complicated, right? The good thing is that the ADX is a common indicator that traders can use immediately in most platform charting packages.
How do you apply ADX in your trading strategy?
Now that we know how it is calculated, the next question is, how do you apply it? The great thing is that ADX is versatile and works well with other indicators. Here are some examples of applying it in your strategies.
During stock selection
Since ADX helps traders gauge the quality of a trend, any investor or trader that uses or wants to apply trend-following strategies can use the ADX value of 25 and up as their cut-off when trading securities to ensure that they only trade or invest in securities that are considered in a strong trend.
Combine with other indicators
As the ADX helps evaluate trend strength, traders and investors can use it alongside other indicators to enhance their trading strategy. For example, you can combine it with RSI to determine the speed of the price movement/momentum. So when the momentum changes to bullish, and ADX registers a value above 25, you can wait for your buy signals to enter the trade.
Trend traders can also use ADX when employing risk management. When the ADX goes below 25, they can use it to signal the trend’s lowering quality and employ tight stops or take profit.
Pros and Cons of ADX
Even with its complex calculations and usage, ADX has strengths and limitations. As an investor or trader planning to capitalize on it, you must understand both sides of ADX. Let’s take a look.
Trend strength identifier – ADX excels in determining the prevailing trends strength, enabling traders to determine if the security’s current trend is robust or just erratic price movements.
Trend-following filter – It proves useful for traders employing trend-following strategies, as it signals opportune moments to enter or exit trades based on trend strength.
Objectivity – Its reliance on mathematical calculations helps remove subjectivity from the analysis. This ensures a consistent and reliable interpretation of the current trend strength.
Lagging – Like with other indicators, it follows the same weakness as the others. Its reliance on it relies on historical price data makes it susceptible to late identification of the trend’s quality due to lag and provides inefficient entries and exits.
Lacks directional insight – While its trend strength identification is one of the best, its inability to provide information on the trend’s direction and the consideration of external factors influencing price movements forces most users to combine it with other tools.
Underperformance in choppy markets – With its exceptional ability to help qualify trend quality, it lacks the oompf in sideways markets. It can potentially generate false signals and lead to losing trades.
Additional applications of ADX
Now let’s look at additional scenarios where you can apply ADX.
Complement chart patterns
Complement charts pattern strategies, like Head and Shoulders, wherein as prices broke out of the trendline and pattern, ADX went above 25, indicating a strong trending move.
Add context to emerging trends
ADX can help confirm any emerging trends strength as a viable reversal or potentially just a fakeout and help avoid whipsaws in trades.
Supplement buy signals generated by other indicators.
Like in the previous examples, ADX provides additional confirmation on trade ideas. The Moving Averages generated a potential buy signal in the sample below as prices traded above them. ADX followed suit after a few trading sessions confirming the strengthening of the newfound trend.
ADX is a valuable tool in a trader’s arsenal, aiding in trend identification and providing essential information for decision-making. However, its limitations must be acknowledged, and traders should utilize the ADX with other indicators and comprehensive market analysis to enhance their trading strategies and optimize their chances of success.