How the ADX Indicator can Help you Identify the Strength of a Price Trend
In order for traders to open successful positions, they will first need to identify the current trend that is at play. Are markets generally bearish or bullish? If markets are bullish, does this warrant opening a long position in a specific, underlying asset?
Though knowing the current strength and direction of the price trend cannot guarantee that opening a long position will be a success, it can certainly be quite helpful. By paying close attention to the way these trends are playing out, you can reduce the risk of trading while simultaneously increasing your long-term winning percentage.
In order to evaluate price trends a bit more objectively, most traders will have a base set of technical indicators that they use on a regular basis. Technical indicators are quantitative measures that help traders determine where prices are most likely to move in the near future.
As you might expect, there are many different technical indicators used on Wall Street and throughout the rest of the trading community. Among the most popular technical indicators, you will find trend strength indicators. As the name suggests, these particular indicators not only reveal the current price trend, but also how strong that trend actually is. When trends are relatively strong, the risks that come with opening a trend-positive position consequently decrease.
One of the most popular trend strength indicators is known as the average directional index (ADX). This indicator is remarkably easy to read and can also be applied in a wide range of market situations. In this article, we will show you how to use the ADX indicator to improve your current trading strategy.
What is the ADX Indicator? How is the ADX Indicator calculated?
The ADX Indicator is the shorthand term for the average directional index. Contrary to what the name suggests, the indicator itself is actually non-directional. This means that the ADX indicator will only tell you how strong the trend actually is—it will remain up to the trader to determine the direction (which can usually be easily determined by looking at a price graph).
The ADX Indicator ranks the strength of the price trend on a scale of 1 to 100. Because the indicator itself is non-directional, low scores will always be indicative of a weak trend and high scores will always be indicative of a strong trend. The “cut off” for where a trend can be considered actionable will depend specifically on your personal risk preferences. Generally, trends below 25 are considered non-trends, trends between 25 and 50 are considered moderate trends, trends between 50 and 75 are considered strong trends, and trends above 75 are considered extremely strong trends.
The ADX Indicator is traditionally measured over a period of 14 bars, allowing it to be easily used in intermediate-term trading strategies. This timeframe can be adjusted, depending on your trading objectives.
The ADX Indicator is calculated from two directional movement indicators (DMI).During the calculation, both the positive and negative DMI will need to be accounted for.When the difference between the forces pushing prices upwards (+ DMI) and the forces pushing prices downwards (- DMI) is significant, the corresponding ADX Indicator will be relatively high. On the other hand, when there is not a large difference between these forces—whether they are non-existent or just canceling each other out—the corresponding ADX Indicator will be notably lower.
What are the pros and cons of using the ADX Indicator?
Naturally, if you are deciding whether to use the ADX Indicator—or any technical indicator, for that matter—you will want to first consider the pros and cons. When compared to other technical indicators available (of which, there are many), the ADX Indicator is usually described in the following ways:
- Easy to Read: the ADX Indicator takes place upon a non-directional spectrum, making it easier to read than other, more complex indicators. When values are high, the trend is strong. When values are low, the trend is weak—it really is that simple.
- Intermediate Term:the ADX Indicator accounts for 14 trading periods (usually, about two weeks). When compared to other technical indicators, this period is relatively intermediate. However, if you are hoping to develop a day trading or position trading strategy, you may want to consider using other indicators.
- Customizable:in addition to having the option to adjust the 14 day trading period, you can also adjust the way you interpret the data. For example, if you are risk averse, you may want to wait until the ADX Indicator breaks 75 before opening a new position.
On the other hand, the simple nature of the ADX Indicator causes it to be lacking detail that many traders are looking for. Some of the commonly cited drawbacks of the ADX Indicator include:
- Limited Information: because the ADX is non-directional, you will need to have additional information (such as raw DMI) in order to make any permanent trading decisions.
- Limited Originality:the ADX Indicator makes it easy to objectively measure the strength of a current price trend. However, most of the information that can obtained from this indicator is not particularly “unique” and could likely be found elsewhere. There are very few instances when the ADX will be calling for a buy or sell in a way that other technical indicators are not.
These drawbacks should not cause you to dismiss the use of the ADX. As long as you are able to use additional trading data, the indicator itself is still remarkably reliable.
How can I effectively introduce the ADX Indicator into my current trading strategy?
Now that you are familiar with the ADX—an indicator that attempts to quantify the strength of a price trend—you may be looking for ways to introduce it into your own trading strategy. In order to reduce your exposure to risk and maximize your potential for strong returns, consider the following strategies:
- Connect Stop Losses Directly to the ADX: once a trend begins losing strength, you will have a limited window to exit your position. Issuing direct stop losses can help you cash out while you’re still in the green.
- Look at +DMI and –DMI: the ADX is a product of two directional movement indicators (usually featured on the same chart), one positive and one negative. By looking at the DMI lines, you will be able to determine the direction of the trend as well as the strength of the trend.
- Understand your Personal Risk Preferences: while some traders will jump into a position as soon as the ADX crosses 50, others will wait until the indicator itself has become a bit more “sure of itself.” In order to identify your own preferences, it will be helpful to trade on paper in advance.
- Use Other Types of Indicators: the ADX is incredibly useful, but it only offers a limited amount of information. Accounting for things such as news events (fundamental indicators), trading volume, and momentum can help you get a more comprehensive view of the market.
As long as you are able to take these simple steps, using the ADX Indicator can immediately enhance your trading strategy.
In order to know whether a position should be entered into, it will be helpful to know how strong current price trends actually are. Instead of speculating and trading once the market “seems” like it’s moving upward, the ADX Indicator can help you quantify the current trend and make your choices accordingly.