Trading the trend is a trading approach where you find the main trend in a market, take a position, and ride the trend to its conclusion.
The important part of trend trading is that there must be a trend that is either just starting or has strength behind it. Getting on board a directional movement can reap some grand rewards and traders may want to investigate a trend trading strategy approach.
The ADX trading indicator (average directional index) is a technical analysis tool we can use to measure trend strength objectively.
ADX – What Is It?
The ADX 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 Indicator.
These values are combined and smoothed to yield the ADX. For those who want the raw data behind the ADX 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, the ADX 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. Perhaps you use a moving average and the ADX level could be used in a trading plan:
- ADX indicator is above 25 and sloping upwards – strong directional movement. Trade the trend.
- ADX is sloping downwards but above 25 – sit aside as the up trend may be weakening.
- ADX is sloping downwards and below 25 – range trading strategy
What we can say though is that as long as the ADX is rising, the trendiness in the market is increasing, and as the ADX drops the trend is weakening.
Technical Indicators Lag Price
Like all the indicators, the ADX lags price and because of this, you would not use the ADX to set up your trade, but you can use it to filter your setups. On the price chart, you would take signals from your trend following system during the highlighted periods, whether they are long or short signals, and stand aside otherwise.
ADX/+DI/-DI Strategy Variation
Another approach uses a separate threshold to indicate the end of the strongly trending period but with one drawback: you may miss a portion of the trending move.
- We would stop taking setups when the ADX falls below 40.
- If the ADX never rises above 40, then you wait until it falls back below 20
The areas in blue end once the ADX indicator drops below 40 except the middle one which never hits 40 before dropping back below the 25 level
Note that this approach avoids the chop at tail end on the first portion of the chart.
Moving Average + ADX Indicator
Remember that a rising ADX 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 ADX line.
This chart has a 9 period moving average (white line) added to the ADX panel and we are only interested in this chart at the points where the ADX line is above the moving average. When the crossover signal happens as seen in the blue boxes, we can apply our trend following trading strategy.
Compared to the prior two approaches, this gets us into the trend sooner and has us standing aside sooner. Because the trend can still continue even though it is weakening, we will miss out on a portion of the price move however.
You can also plot the difference between the ADX and the average as a histogram for a nice clean look. A positive histogram says you can take setups, a negative one says stand aside.
Remember that the ADX should be used as a filter, not as its own setup. Use it in combination with a trend following trading strategy, price action or technical indicators, and only take setups when you have ADX confirmation using any of the approaches discussed.
A good trend following system should also include a sound stop and risk management strategy. You may want to use a trailing stop strategy when trend trading to take advantage of what the market is willing to give.
Don’t wait for the ADX to tell you to get out of the trade, it will be too late.