The average directional index, ADX for short, is a technical indicator that measures the strength of a trend.
Given that most instruments spend more time in a consolidated environment, it is helpful to know if your market of choice has any life to it. The state of the market and how to use technical indicators in that market state, is vital to know.
There is nothing more frustrating that attempting to take trend trades when Forex trading for example, only to do so in a weakly trending market.
What Is 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. For those who want the raw data behind the calculation, you can find that information at this link.
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 trend following systems.
Traditionally an ADX value above 20 indicates a trending market. The exact threshold can vary, and some use 21 or 25. Any time that the ADX is above this value we can use a trend following strategy such as trading pullbacks or breakouts in the direction of the current trend.
When it is below then it’s below we can consider use a fading strategy such as a failure test of support or resistance.
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.
- ADX line is below the 25 level and we would consider trading failure tests or support/resistance rejections. Look at the price action = range trading condition.
- ADX line is climbing above 25 and we would look to trade the trend. The price action here is conducive to trading.
You would have to determine the trend direction in another matter.
How To Read The ADX Indicator
I want to talk about the basic form of ADX as opposed to the DMI version and the difference between the two.
While some traders use the crossing of the directional movement lines as trade entries/trend direction, I take them off the chart.
- ADX is composed of one line and helps a trader determine if a market is trending and that strength of that trend
- The DMI version consists of three lines, including the ADX line, plus two lines called directional movement lines
- DM+ and DM- are often used to determine trend direction and can be used as buy and sell signals when they cross (Di crosses)
Traders have to understand the limitations of lagging technical indicators and their ability to get caught up in the market noise. I prefer using structure and price action along with trading indicators for a complete trading strategy.
The indicator fluctuates between a high of 100 and a low of zero and there are levels inside that range that traders pay attention to.
Here are the readings to quantify trend strength.
- 0 – 24 is considered a weak or non-existent trend in the market
- 25 – 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
- The setting of the ADX indicator is set to 14 periods
I have highlighted areas on this chart of Bitcoin that traders would want to pay attention to in this bearish trend.
The two orange lines are the 25 and 50 ADX readings where you would determine the strength of a trend
- When the market is below 25 you can see through price action that trading those areas on the chart would be tough as a weak trend is in place
- Between the lines where the ADX is above 25, we can see that there is price movement that is you had a sell signal, you could trade off of.
- Above ADX 50, we want to watch for signs a strong trend is about to end. A turn down in the ADX shows the trend is losing strength
Note that the slope of the ADX is not related to the trend direction.
How To Trade Using The ADX Indicator – 2 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 25
- 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
- Those that look for divergence would have their own approach
How To Use ADX For Breakout Trades
Heading back to the Bitcoin price chart, I used a vertical line to show where ADX has fallen below the trending cutoff point
During the 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. I have used dashed green lines to mark off the high and low of the range.
- Price is making higher lows into resistance as shown by the blue line. That is bullish.
- We have small basing underline in red just under resistance and this is also bullish
Trade entry for a long trade can be inside the smaller base and the stop loss can be under the range or through an ATR stop loss setting.
Initial targets for profit or trade management is the size of the range in height projected from the breakout level.
Pullback Trading Strategy – Trend Trading – ADX Shows Strength
When trading continuation trades, we want to ensure the market we are considering has some energy to it. When scanning our charts, looking for ADX +25 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.
Since we prefer to trade a trend that is showing signs of strength, we can use an ADX/Moving average combination which allows us to focus on a rising line.
For this example, I have included the 20 period moving average for our price directional movement indicator. Check out the article on how to use moving averages with your trading to learn how to properly use them.
Our approach will be using bull flags and bear flags in various forms.
- Price hugging the moving average shows a market in balance. You can see the ADX is below 25 and trend traders would ignore this currency pair at this point
- This trend line highlights a break of the weak down trend however…..
- Shows trend strength forming. With a break of the trend line, we are bias towards long trades
- After a two day rally after the trend line break, we get basing at highs of the one day momentum. This is bullish. Trade the breakout of the basing or use it as information
- Pullback and trend line break plus ADX over 25 and rising
- Ascending triangle, basing below resistance, look for the long trade
- ADX is reaching level 50 and traders should start to pay attention to managing the trade closely
There are many ways to handle buy signals in this case. Simple trend line breaks, inside candles, breakouts of previous candle highs.
Stop loss would be handled the same way you would with pullback trades – ATR or below pivots with some wiggle room.
Effective Use Of The ADX
Keeping in mind the ADX is a lagging indicator, there are some uses that traders may find beneficial
Trend strength is the one that most traders use it for but you can often tell the strength of the market by looking at the relationship of each swing in price.
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 +25
- 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.
Another way to use the ADX is to screen for instruments with ADX +50 and look for extreme trend strength. Using a technical analysis approach such as failure tests, you could find counter trend trades that are set up by extreme strength in the other direction.
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.