How to best use the ADX indicator: Unleashing the power of trend analysis

The Average Directional Index (ADX) is a powerful technical indicator that helps traders evaluate the strength of a trend in the stock market.

Developed by J. Welles Wilder, this indicator is part of the Directional Movement System, a set of tools designed to identify market trends and determine their intensity.

In this blog post, we dive into what the ADX indicator is, how it works and how best to use it in your trading strategies.

What is the ADX Indicator?

The ADX measures the strength of a trend, regardless of its direction, on a scale from 0 to 100. It is often displayed alongside two other lines: the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). These components work together to provide a comprehensive view of market dynamics:

ADX Line: Shows the strength of the trend. A rising ADX indicates a strengthening trend, while a falling ADX suggests weakening momentum.

+DI Line: Reflects the strength of upward price movements, indicating a bullish trend.

-DI Line: Reflects the strength of downward price movements, indicating a bearish trend.

The ADX does not indicate trend direction on its own. Instead, traders rely on the +DI and -DI lines to interpret the direction.

How is the ADX Calculated?

The calculation of the ADX involves several steps:

Directional Movement (+DM and -DM):

• +DM: The difference between today’s high and yesterday’s high (if positive).

• -DM: The difference between yesterday’s low and today’s low (if positive).

If both +DM and -DM are positive for the same period, only the largest value is used. The indicator with the smallest value is set to 0.

True Range (TR): The largest of the following:

• Current high minus current low

• Current high minus previous close

• Current low minus previous close

Directional Indicators (+DI and -DI):

• +DI = (Smoothed +DM(14) / ATR(14)) × 100

• -DI = (Smoothed -DM(14) / ATR(14)) × 100

The default time interval used for this indicator is 14. Consequently, the moving average for the Average True Range is also 14 periods.

DX (Directional Index):

• DX = (|+DI(14) - -DI(14)| / |+DI(14) + -DI(14)| ) * 100

ADX (Average Directional Index):

ADX is the smoothed average of DX over a specific number of periods, typically 14.

Interpreting the ADX Indicator

The ADX provides valuable insights into market conditions:

• ADX Below 20: Indicates a weak or non-existent trend. The market may be range-bound, making it suitable for mean-reversion strategies.

• ADX Between 20 and 25: Signals the potential start of a trend but lacks confirmation of significant strength.

• ADX Above 25: Suggests a strong trend, ideal for trend-following strategies.

• ADX Above 50: Confirmation of strong trend, the higher the ADX, the stronger the trend.

The interaction of the +DI and -DI lines further clarifies market direction:

• +DI Above -DI: Indicates bullish momentum.

• -DI Above +DI: Indicates bearish momentum.

• Crossovers: When the +DI crosses above the -DI, it may signal a buy opportunity. Conversely, when the -DI crosses above the +DI, it may signal a sell opportunity.

How to use the ADX in your trading strategy?

A few practical considerations to best integrate the ADX into your trading:

Confirm Trend Strength:

Use the ADX to confirm whether a market trend is strong enough to trade in. For example, if the ADX rises above 25, this is an important indication that the trend has enough momentum to warrant a position.

Avoid range-bound markets:

An ADX below 20 is an important warning for traders using trend-following strategies to avoid taking a position in range-bound markets, where false signals are typically frequent.

Identify trend reversals:

Watch for crossovers between the +DI and -DI lines. Combined with a rising ADX, these crossovers can signal the beginning of a new trend - and thus trading opportunities.

Combine with other indicators:

Combine the ADX with moving averages, RSI or other momentum indicators to build a more comprehensive trading strategy. For example, an ADX above 25 combined with a moving average crossover can be a strong confirmation for entering a trend.

Divergence signals between ADX and price action

Divergence between how the ADX indicator evolves and the price evolution can provide important clues about potential trend reversals or declining momentum. These can be used to manage existing positions (tighter stop loss) or even to take a new short position speculating on an effective trend reversal.

• Occurs when the price makes a higher high, but the ADX value fails to confirm with a corresponding high.

• This indicates that the upward momentum of the trend is losing momentum, increasing the likelihood of a downward reversal.

Divergences can be particularly useful when combined with other technical analysis tools such as support and resistance levels, chart patterns or moving averages to validate potential trade setups.

Advantages and disadvantages of the ADX indicator

Advantages:

• Strong and clear visuation of trend strength
• Helps traders avoid range-bound markets in trend-following strategies
• Can be combined with other indicators for greater precision.

Disadvantages:

• Please note, the ADX indicator itself does not indicate trend direction, only the intensity of the prevailing upward or downward trend. For trend direction itself, the +DI and -DI lines should be interpreted.
• Because the indicator focuses on trend momentum, it is less suited to reacting quickly to trend changes (although the divergence signals do help).

ADX features in ChartMill

The ADX is available as a technical indicator. You can adjust the time period and choose whether to make the indicator visible above, below or even on the price chart.

But that's not all. ChartMill also allows you to use the ADX as a technical filter screen.

To do so, open the stock screener page and click on the TA Indicators tab. Here you will find the filter field 'ADX' with numerous options to define specific conditions based on this ADX.

Final Thoughts

The ADX indicator is an interesting tool for assessing trend strength and momentum.

That makes this indicator especially useful in trend following strategies where an ADX value < 20 is a sign of rather unfavorable market conditions, where the probability of false signals is significantly higher.