Following trends closely is part and parcel of trading. But how can you determine the strength of a trendline? The ADX indicator is a common solution for professional investors, analysts, and individual traders alike. Keep reading to learn how this trend strength indicator works as well as how to apply it to your own investments.
ADX indicators explained
The Average Directional Movement Index, or ADX, is a popular trend indicator designed to measure the moving average of price range expansion values. Developed by Welles Wilder, it’s one part of the Directional Movement System which aims to measure price movements and their strength. Whether a trend is going up or down, it’s shown on a graph with two accompanying indicators:
Negative directional indicator (DMI-)
Positive directional indicator (DMI+)
When you’re looking at the ADX, you’ll see three separate lines to show the trend along with these positive and negative directional indicators. You can use this type of trend strength indicator to measure the price movements of many different types of securities and trading vehicles. ADX can be applied to stocks as well as mutual funds, ETFs and futures.
How an ADX trend indicator works
You can plot the ADX as a single line, with its values ranging from zero at the low end to 100 at the high end. The indicator measures trend strength rather than price, so it can be used equally for prices trending upward and downward. In most cases, you’ll plot the indicator alongside the directional indicator lines (DMI) mentioned above.
So, what do these lines tell us?
If the DMI+ line sits above the DMI- line, this means that prices are trending up. The ADX line measures the strength of this upward trend.
If the DMI- sits above the DMI+, this shows that prices are trending downward, with the ADX line measuring the downtrend’s strength.
When ADX is below 20, no trend is present.
When ADX is above 25, a strong trend exists.
If the ADX line is starting to turn down from its high values, it signals the end of an upward or downward trend.
If the ADX line is starting to rise, the market is showing a strengthening trend.
How to calculate ADX
While it looks quite complicated written out as a formula, the ADX indicator involves a straightforward calculation. ADX simply represents the average, or mean, of the DMI numbers over a specific period of time.
To get started with calculating ADX, you’ll need to first calculate the DMI+, DMI-, and true range for the period. In most cases, fourteen periods are used. It’s easiest to use trading software to calculate these figures and smooth them into an easy-to-read graphic format with three lines.
How to trade using ADX indicators
We’ve already covered a few of the main points to keep in mind when looking at how to trade using ADX indicators. For example, an ADX over 25 indicates a strong trend, while an ADX below 20 indicates a weak trend. What does this mean for traders? A declining ADX might show you that the market trend is weakening, which means you should avoid trading based on this trendline. On the other hand, when the ADX begins to rise by four or five units, this shows that it’s time to trade according to this trend.
In any case, the ADX stock indicator should always be looked at alongside price. Price movements are the main signals to watch, but ADX can help by pointing out the strength of these trends. When there are sudden breakouts from the normal price range, you can look to the ADX indicator to determine whether these are a one-off event, or a continuing trend.
Overall, the ability to identify strong trends is extremely valuable to traders. By using ADX along with price, you can identify trending conditions and make more profitable trades with less risk involved.
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