Trades that are in line with a trend have lower risk. A successful trade requires the ability to identify a strong market trend. This skill is essential for every trader. How do you know if a trend is strong or weak. It is worthwhile to follow a strong trend as it increases your chances of profit. However, if the trend is weak it could lead to loss.
The ultimate indicator of a trend, the average directional index (ADX), will tell you if it is worth following. The average directional indicator, minus directional Index (-DI), plus directional Index (+DI) are all indicators that can help you determine the direction and strength of a particular trend.
When planning a trade, it is important to determine if the underlying currency is trending. Stock prices spend more time in consolidation then in trending, which can lead to multiple drawdowns. ADX can help you determine the strength of a trend.
ADX is calculated based on a moving average price over a time period. It is shown as a line with a range of zero to 100. It was created by Welles Wilder Jr. to measure the direction of commodity prices and their price movements. However, ADX is widely used for stock market analysis.
The basis of Wilder's Directional Movement System is the two, plus and minus indicators. Trend direction was derived by comparing the differences between two consecutive lows and their highs. Directional Movement Indicators, also known as plus and minus indicators, are calculated from the average of all differences over a given period. The smoothed average difference between +DI (or -DI) and -DI is used to calculate the ADX indicator. The strength of a trend is measured using ADX. DIs measure its direction. ADX default settings are 14 bars, but you can adjust it for other times. ADX is not directional. Together, the DIs (and ADX) measure the strength and direction of a trend.
Price movement in a trend is not constant. Even when the price is rising, there are periods of temporary drawdowns. Directional movement can be used to compare two consecutive lows and their respective heights. This allows you to determine if DI is positive/negative.
The DI is positive if the difference between the prior high and the current high is greater than the difference between the prior low or current low. If the difference between the prior high and current high is positive, the DI is considered positive. Negative values are entered as zero.
The DI is also negative if the difference between historical lows and current lows is greater than that between current highs and previous highs. Negative or minus DI must have a positive difference between the previous low and current lowest. Negative values are entered as zero.
These DI points are plotted against each other in a trading chart to form a DI line. The price moves upward when the +DI is above the -DI. The price moves downward when the negative DI is higher than the plus DI. The strength of the trend is measured using ADX.
In both cases, the +DI rises over the -DI. Conversely, the ADX rises when the –DI is above +DI. This indicates the strength of the trend.
The strength of a trend is determined by the average directional index. It doesn't tell if the trend will be bullish or bearish, like other indicators such as RSI. The following is what ADX does:
- Showing trader when the market trend is
- Helps traders to chase the trend by filtering out anti-trend moves
- This tool allows traders to identify profitable trends
ADX is used to determine whether a price has entered a range or is in trending conditions.
- This allows traders to trade trend strategies when the trend has a strong hold, and not when it is going sideways.
ADX is the smoothed mean of the Negative Directional Indiator and Positive Directional Idicator. It doesn't have any negative value.
Below is a chart that shows the ranges of ADX and the interpretation associated with them
|ADX Value||Trend Strength|
|0-25||A weak trend or an absence|
|75-100||Extremely strong trend|
Many traders believe that ADX above 25 is a strong trend. ADX below 25 indicates the point of accumulation or distribution. If ADX is below 25 for 30 bar, the price will usually move in a range and oscillate between support and resistance levels in order to find selling and buying opportunities. The price will begin to trend after the low period.
Technical trading requires that you correctly interpret ADX. ADX does not indicate a trend reversal. It simply indicates whether the trend is strong enough. Sometimes falling ADX can be misinterpreted as a sign of a trend reversal. Falling ADX is not a sign that the trend is slowing down. To determine ADX, you can use the simple rule of thumb.
A trend that is below 25 ADX indicates a weak one
If the ADX is above 25 or rising, then the trend is strong.
If the ADX is higher than 25 and is falling, it indicates that the trend is slowing.
ADX peaks can be used by traders to determine when trend momentum is strong. A higher ADX peak indicates that price momentum is strong, while a lower ADX peak suggests that momentum is decreasing.
- A trend that is strong despite low peaks, has an ADX above 25
- Even though ADX is declining, an uptrend can see the price rise as overhead supply increases with the trend.
If the price is rising but the ADX is falling, it means that the trend is losing momentum. However, the uptrend is continuing
ADX causes a momentum divergence if the price reaches a higher high but ADX reaches lower highs. It causes a negative divergence
- A phase of non-confirmation is indicated by a negative divergence.
Contrary to divergence, traders can profit from trend momentum rising without having to exit the trade. ADX divergence, on the other hand, indicates that momentum is declining so that a tighter stop-loss may be applied.
ADX allows traders to identify when a breakout is strong enough for them to expect a trend. A breakout is when the sellers and buyers disagree, and it causes a trend reversal. But, many breakouts fail to make it past the trap and become a trap. ADX is a measure of strength that indicates whether a breakout is strong enough for it to become a trend. If ADX is above 25, then it's a strong trend to be following.
As a range finder, ADX indicators can also be useful. If ADX falls below 25 or above 25, it is a sign of a weak trend. This range indicates that the trend is sideways. Until the equilibrium between supply and demand shifts, the ADX will be at this level.
When combined with the price, ADX can help to create a winning trading strategy. This helps you identify when the price is trending and allows you to create a strategy that follows the trend. The pullbacks can be used to enter a trending price.
ADX is a powerful indicator but there are some flaws you should be aware of.
1. ADX indicators wouldn't apply to stocks that are unusually volatile or slow-moving.
2. ADX is calculated on the moving average. This is a laggard indicator. ADX is therefore very slow.
3. Crossovers between +DI/-DI are very common and can lead to false signals
4. ADX can be used in conjunction with oscillators and other indicators
Technical trading is based on the trend. Although traders use many indicators and trading patterns to determine trend direction, none of them are as useful if you want to know the strength of the trend. The ADX indicator fills in the gap by quantifying trends strength. It also helps you determine when the price moves within a certain range, so you don't have to waste time trying trend trades. It can also be used to manage riks, as an ADX indicator signal when momentum slows. ADX is essential if you are to be successful in trend trading.