- January 18, 2021
- 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.
Statistics show that markets will spend more time in a consolidated state (trading ranges) than they will trending. That is vital to know especially if you have two main trading strategies:
- Trading strategy that trades pullbacks will need a trending environment
- Trading ranges or range breakouts that need consolidation
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 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.
- ADX is above 25 and rising which means a trend is underway and is getting stronger
- ADX is dropping and while technically still a trend, you can easily see on the chart price action is not really gaining (or losing) ground
- ADX is well below 25 and in a trading range
You would have to determine the trend direction in another matter such as price action or another trading indicator.
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
- DI+ and DI- 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.
ADX fluctuates between a high of 100 and a low of zero and there are levels inside that range that traders pay attention to.
Trend Strength Readings
- 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
Understanding these ranges can also assist traders in managing their trades including taking profits.
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 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
One truism about trading – you have to know who you are as a trader.
Breakout Trading Using ADX Indicator
This is the daily chart of Bitcoin and many traders are just wanting a good place to enter.
This is where the ADX can help.
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.
- ADX is rising while below 25 which, by the price action direction, we know we are getting upside strength
- This is a trading range and we actually have a series of inside candlesticks.
Since the nested range is close to the resistance zone, the probability is more upside. Having a range trading plan can help you get into a position to take advantage of the breakout that we know, eventually, will happen.
Initial targets for profit or trade management is the size of the range in height projected from the breakout level. Since this is Bitcoin, many people will just hold.
ADX Pullback Trading Strategy
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.
To determine trend direction, we will use the 20 period EMA. When the ADX is rising, we will only consider short trades.
This is a 30 minute Forex chart and I made sure to pick a chart that didn’t look “easy”.
There are a few things going on with this chart:
- Price did pull back while the ADX was above 25. This pullback failed via one of the ways pullbacks fail – they transition to a trading range. ADX drops below 25 signaling weak trend in play. If you were using a ADX >25 scan at this point, you’d skip this chart
- Price again pulled back and while we are in a range, the ADX is >25. Keep in mind this is a 30 minute chart. On the daily chart, you’d be looking at a doji candlestick. You’d be trading a breakout as an entry into this pullback. Unlike a range, we would not set a pattern specific price target because we are expecting the trend to continue
- Small bear flag for shorting
Let’s take a look at a stock chart.
On this chart, there are setups that include pullbacks and trading ranges. Remember, we can scan charts for:
- Consolidated price action with ADX <25
- Trending markets with ADX >25
We will have breakout setups during trending markets where we are looking to rejoin the trend. During periods of ADX <25, we are looking more for trading ranges that could lead to breakouts and a reviving trend or just a price target.
ADX readings and line slope can help with your expectations on a trade. If the ADX is about to break the 25 level, you may consider a different way to manage a trade as you expect a trend to begin.
Don’t forget that while you can enter via price action such as failure tests of lows and highs (as we see with the last trading range), using a trigger as a trade entry can keep you away from guessing…and hoping!
Effective Use Of The ADX
Trend strength is a scan that most traders use 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 <25
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?
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.