- March 24, 2022
- Posted by: CoachShane
- Categories: Trading Article, Trading Indicators
Using the ADX is an objective way to measure the strength of the trend (trend momentum) in the instrument you are considering trading. A trader that may have both a pullback/reversal strategy and a breakout strategy, will find usefulness in knowing the strength or weakness of the current trend.
This trend strength indicator will let you know if you should use:
+ A trading strategy that trades pullbacks that need a trending environment
+ A breakout strategy that needs a consolidation of price
The ADX (average directional index), can be a quick way to determine which strategy you should actually use.
Background Of The ADX
The average directional index was developed by Welles Wilder to identify periods of trending price action. The calculations for the indicator are based on changes in consecutive bar highs (+DI) and consecutive lows (-DI). DI stands for Directional Movement Indicator. These values are combined and smoothed to yield the ADX.
The original design of the ADX, +DI and –DI were the basis for a full trading strategy and all that had to be added was a risk management strategy. In the trading world of today, it is often used as a standalone filter for the current trend in trend following systems.
Traditionally an ADX value above 20 indicates a trending market. The exact threshold can vary, and some use 21 or 25. Below those values indicates a possible consolidated markets.
Note that the ADX itself does not indicate the direction of the trend, it simply tells us that the market is trending, either strong or weak.
How to read ADX
ADX indicator is set to 14 periods
0 – 20 is considered a weak or non-existent trend
21 – 49 would be looked at as a market that is trending and trend trades can be considered
50 – 74 is a strong trend and traders should be looking to lock in any profits or at least reduce risk
75 – 100 is an extremely strong trend and traders should be on alert for sudden price shocks against their position
Rising ADX – Current trend is beginning to get strong
Falling ADX – Current trend is getting weak
You would have to determine the trend direction in another matter such as price action or another trading indicator.
2 ADX Trading Strategies
There are two main ways we can use it as part of a trading system but first you must know how you trade.
Is day trading what you prefer? Are you more a swing trader? Are your time frames the weekly charts?
How about your approach to trading?
Trend traders looking for continuation trades through pullbacks or range breakouts, would scan for markets that read over 20 with a rising or sideways line
Traders who look to trade breakouts from a trading range looking be in the market before the trend moves, would look for less than 25
Breakout Trading Using ADX Indicator
This is the daily price chart of Devon Energy and is a good example a breakout play with the ADX.
During a stock scan, we find the indicator showing a weak or non existent trend (range conditions) and in doing so, we look for a consolidation structure for breakout trading.
As price begins a price pattern of lower highs and lows, at number 1 we the ADX sloping down and heading under the 20 level. This is your sign that any trend, is weak. The line at number 2 is the previous swing high and we see a fair amount of price action without clear direction under it.
At number 3, price moves close to the resistance level and unlike the other times, price forms a smaller range near the highs. This is bullish.
Number 4 sees a rising ADX followed by a strong breakout. ADX continues to rise over the 20 line showing us a strong uptrend is forming.
ADX Pullback Trading Strategy
When trading continuation trades, we want to ensure the market we are considering has some energy to it. Scanning our charts and looking for ADX +20 can have us dig deeper into the chart with technical analysis.
Remember that a rising line indicates a strengthening trend, and a falling ADX a weakening trend. To determine trend direction, we will use the 20 period EMA for a directional indicator.
Daily chart of Peabody Energy and the 20 period moving average shows an overall uptrend.
Price has broken out and has pulled back to the breakout point. With the rising ADX showing momentum coming into the instrument and over being 20, this is a viable long trade.
Further on the right, we have a complex pullback and a declining ADX. The trend is still strong but is losing a bit of steam as price moves into the previous high. Any trader long into resistance with a declining ADX, may want to manage their stops in case of a strong rejection to the downside.
Needing to see a rising or flat ADX and a reading over 20, is a good way to narrow down your watchlist of potential pullback trades.
Effective Use Of The ADX
Trend strength is a scan that traders can use to narrow down their focus list. While you can see the same thing by reading price action, it is a fast and dirty way to scan through your charts to find where your focus should be.
+ Trend traders would look for ADX >20
+ Breakout traders would look for ADX <20
An example would be Forex traders looking for a currency pair to trade could compare the ADX readings. Which currency pair is strongest when comparing USD crosses, for example?
Best ADX Settings
As with most technical indicators, you can adjust certain settings. You can adjust the lookback period or the levels you need to see to show a strong trend. Generally, 14 or 20 is the standard lookback period. Shorter periods will make an indicator more responsive but can also give false signals.
Levels can range from 20-25 for signs of a trend and 45-50 for extreme trend strength.
Using 50 as an example, you’d find instruments that may be overextended and looking for a reversal. Using a technical analysis approach such as failure tests, you could take advantage of the markets tendency to mean revert after a big move.
Ensure you have a written trading plan that includes the ADX reading you need as well as risk management so you can survive a run of losing trades.
If you found this information about the ADX useful, here are other resources to assist you in making a trading strategy.