Monday, 4 July 2011

Decoding for ADX (Average Directional Index) Indicator

A famous and popular maxim in trading world suggested "The trend is our friend"! The idea is to go with the market prevailing trend instead of fighting with it. Thus, analysis to identify the curvature of the trend become more and more important. One of the useful indicator for this analysis is through ADX (Average Directional Index) where we will use it to spot the folllowing:

1. Trend direction -- Uptrend or Downtrend
2. Point where trend changed from uptrend to downtrend or vise versa
3. Momentum of the trend


This indicator was created by J.Welles Wilder as an indicator of trend strength and is widely used in technical analysis during stock trading.

Average Directional Index (ADX) was created by J. Welles Wilder as indicator to depicts a presence or absence of a trend. It is important to identify if market is trending or it is moving sideways (no trend). In other words, ADX advices on-trend tendencies: whether the trend is going to continue and strengthen or it is about to lose its positions. That's why ADX become widely used indicator in technical analysis. ADX is calculated by formula:

Average Directional Index (ADX)

How to interpret ADX

ADX looks at the average directional strength over the last N number (Normally the period used is 14) of periods. ADX indicator consists of 3 lines: ADX (Green), Positive Directional Indicator (+DI in Blue) and Negative Directional Index (-DI in Magenta). To interpret this indicator, trader would need to draw the horizontal line at the level of 20 & 40 as per figure below below:

ADI is ranging from 0 to 100. Any ADX reading below 20 considered as a weak and unclear trend (side way) while reading above 20 indicate that a trend has picked up. If the reading break above 40. This would represent an extreme strong trend. That is, basically simplest explanation of the purpose of ADX. ADX signals can be concluded as below:

  • ADX staying below level 20
    • There is no trend or the trend is weak. (Side Way)
  • ADX moving above level 20
    • Trend is Strong (Bullish)
  • ADX moving above level 40
    • Trend is extremely strong (Super Bullish)
  • ADX reading rising
    • Trend is getting stronger
  • ADX reading falling
    • Trend is weakening
  • +DI stays on top of -DI
    • Uptrend is in place
  • -DI stays on top of +DI
    • Downtrend is in place.
  • Two DI cross
    • Trend is changing

How to trade with ADX

Below are some tips how to trade with ADX:
  • Trading with ADX Signals
    • ADX moving below level 20:
      • There is no trend or trend is weak
      • Need to apply non-trend-following strategies as false signals and whip-saws might occur
      • Eg of non-trend following method (Channel Trading)
    • ADX moving between level 20 and 40
      • Trend is strong
      • Could apply trend-following technique
      • Eg of trend-following technique (Forex Trading Moving Averages or Parabolic SAR Indicator)
    • ADX moving above level 40
      • Trend is extremely strong
      • Also suggests an overbought / oversold (depending it is uptrend / downtrend)
      • Time to protect profits and protecting remaining positions with trailing stop loss technique
  •  Trading with +DI / -DI Signals
    • Use to spot entry or exit signals
    • When ADX is below level 20
      • All crossovers would be ignored
    • When ADX is above level 20
      • Buy signals called when +DI (Blue) signal crosses upwards and above -DI (Magenta).
      • Sell signals triggered when +DI (Blue) crosses downwards an below -DI (Magenta)
1. If a opposite crossover happens within a short period of time, the original signals should be ignored (take the latest signals as reference).
2. ADX indicator should never traded alone, it is advisable to trade with combination with other indicators or tools such as Stochastic, RSI, MACD and etc. (We will discuss more on this later)
3. When ADX rises above level 20 for the first time and then goes flat for some time, it is believed new trend is incubated. The reason the ADX is flat is because market is reacting to this new trend formation (making initial correction). It is advisable to initiate a new orders during this correction period.

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