Understanding Average Directional Index (ADX)

Introduction:

Average directional index evaluates the strength of the current trend, be it up or down. The ADX is an oscillator that fluctuates between 0 and 100. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend. A reading above 40 indicates that the trend is strong and a reading below 20 indicates that the trend is weak. An extremely strong trend is indicated by readings above 50.

What does it measure?

ADX does not indicate trend direction, only trend strength. It is a lagging indicator; that is, a trend must have established itself before the ADX will generate a signal that a trend is underway.

ADX can also be used to identify potential changes in a market from trending to non-trending. When ADX begins to strengthen from below 20 and moves above 20, it is a sign that the trading range is ending and a trend is developing.

The ADX indicator does not provide buy or sell signals for investors. It does, however, give you some perspective on where the stock is in the trend. Low readings and you have a trading range or the beginning of a trend. Extremely high readings tell you that the trend will likely come to an end.

Overall, what is important to understand is that this indicator measures strong or weak trends. This can be either a strong uptrend or a strong downtrend. It does not tell you if the trend is up or down, it just tell you how strong the current trend is.

Construction of ADX.

We will not go into the formulas for the Indicator here. However what we need to know is that:

  • ADX is derived from two other indicators
  • The first one is called the positive directional indicator(sometimes written +DI) and the second indicator is called the negative directional indicator(-DI)
  • The +DI Line shows how strong or weak the uptrend in the market is.
  • The -DI line shows how strong or weak the downtrend in the market is.
  • ADX is the average of the above two lines and hence, it shows the strength of the current movement.
  • On screen, the ADX appears below the stock price chart. The +DI (normally a green line) and –DI lines (red line) would accompany the ADX (Black line). So you see three lines as shown in the figure below.

More tips:

  • When the ADX starts rising from a low level it signals the beginning of a trend.
  • The trend is confirmed when the ADX has risen above the 20-25 value and the +DMI line has crossed the –DMI line (in case of an uptrend).
  • The ADX signal generally does not move above 60 or 70. ADX above these levels are considered to be ‘over bought’ levels. When the ADX has reached an overbought level and starts consolidating it can signal the end of the current trend.
  • The decline of the ADX signals the consolidation or indecision of the market.
  • When the ADX drops below 10, the current trend is virtually dead. Be ready for the beginning of a new trend – bullish or bearish. Don’t assume that since your current position has given you an ADX reading of 10 (or lower) implying that your trend is over and that the subsequent ADX move above 20 will take you in the opposite direction. That’s a terribly wrong assumption.
  • An ADX reading above 20 implies the “beginning” of a new trend; whereas; a rise above 25 implies a “trending” market; even a bearish market. So, know this – it is possible to have a reading of 35 and the market can be falling like a rock. An upward moving ADX does not specify market direction – only market trend. This is a very important point to note.

That completes our lesson on ADX. More about indicators in our next lesson.

You may like these posts:

  1. Understanding Moving average
  2. Types of indicators/Oscillators
  3. Understanding MACD

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