ADX, short for the average directional index, is of the best indicators that can be used for assessing the strength of a trend. Here’s how you can use ADX indicator to make better trades.
What is an ADX Indicator?
Developed by Welles Wilder, Average Directional Movement Index is actually a combination of three lines: Minus Directional Indicator (-DI), ADX line, and Plus Directional Indicator (+DI). These are indicated in the figure below as Red Line, Black Line, and Green Line respectively.
ADX, +DI, and -DI lines
The ADX does not indicate the direction of the trend, it just quantifies the strength of trend.
ADX and Strength of Trend
Depending on the value of ADX, it is possible to identify whether the market is trending or ranging and also define the trend strength.
- When the value of ADX is <25, it indicates a weak trend
- When the value of ADX is between 25 and 50, it indicates a strong trend
- When the value of ADX is between 50 and 75, it indicates a very strong trend
- When the value of ADX is >75, it indicates an extremely strong trend
Depending on the trend strength, traders can make decisions regarding which stocks to buy or sell. Low values (<25) of ADX usually signify accumulation or distribution phase depending on the direction of the price movement.
ADX, DI, and Bulls & Bears
- If ADX is below both (+DI) as well as (-DI), it is termed as a lifeless market.
- When ADX is above both (+DI) and (-DI), the market is said to be overheated and prices typically start to move downwards as soon as ADX moves down.
- When the (+DI) is greater than the (-DI), the bulls are said to be in control.
- When the (-DI) is greater than the (+DI), the bears are said to be in control.
How to Use ADX for Trading
Average Directional Index can be used for timing the entry into the stock whenever there is a confirmed dominant direction in the market trend.
Buy in the following set-up
- When (+DI) > (-DI);
- ADX and (+DI) are above (-DI);
- ADX starts rising from below both (+DI) and (-DI).
The exit point for this trade is when (+DI) crosses below (-DI).
Sell in the following set-up
- When (+DI) < (-DI);
- ADX and (-DI) are above (+DI);
- ADX starts rising from below both (+DI) and (-DI).
The exit point of this trade is when (-DI) crosses below (+DI)
The chart below shows a short position entry using ADX.
Entering Short Position using ADX and DI lines
Happy Trading!
Tara
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