Trend chasing is one of the most popular and profitable technical trading methods. Detecting a strong directional move is the cornerstone of a trader’s toolkit. Generally, trend trading attempts to utilise the momentum of an asset in a particular direction to capitalise on gains. This strategy can reduce a trader’s risk and increase profit potential. There are various technical indicators that help traders assess the momentum. One such indicator used to understand the strength of a trend is the Average Directional Index (ADX).

This article covers:

What is the average directional index?

Average Directional Index forms a part of the Directional Movement System. It is an indicator developed by Welles Wilder to fathom the strength of a price movement, either in a positive or negative direction. The ADX primarily determines the core strength of a trend. 

Welles originally developed the indicator for the commodity industry but due to its high relevance and competence, it became a popular indicator for technical trading of stocks as well. 

The ADX is derived from two accompanying indicators: the Positive Directional Index (DI+) and the Negative Directional Index (DI-). Therefore, an ADX indicator has three lines on the chart: DI+, DI-, and the ADX line.

Calculating the ADX

ADX is primarily used to quantify the strength of a trend. ADX is calculated based on the moving average of a price range spanning over a given period. The default ADX is calculated for 14-time units, although other periods can be used. ADX can be used on trading vehicles such as stocks, mutual funds, exchange-traded funds, and futures.

As mentioned before, the ADX indicator comprises three components, namely:

  • The positive Directional Index DI+
  • The negative Directional Index DI-
  • ADX line

The ADX value spans from 0 to 100, and it signifies the trend’s strength irrespective of its direction. It helps traders to spot the strongest trends and, in turn, capture the most profitable trades. 

Usually, readings that are close to 0 or greater than 60 are not common occurrences. It is important to note that the ADX value just signifies the trend’s strength and not its direction. Another important aspect of ADX indicator is DM which stands for directional movement. They are the most important component of the ADX indicator. 

Have a look at the below table to understand ADX indicator in detail.

IndicatorBelow 20Above 20Above 40Below 40
ADXRange for tradingNew trending emergingExtremely strong trendTrend may be weakening
+DIA weak bullish momentumNew/Bull trending emergingExtremely strong bull trendTrend may be weakening
-DIA weak bearish momentumNew/Bear trending emergingExtremely strong bear trendTrend may be weakening

+DI = bulls may be activated generating a buy signal
-DI = bears may be activated generating a sell signal

For calculating ADX, true range (TR), +DM, -DM,+DI,-DI needs to be calculated.
True range = High price – low price (of the day)
DM is calculated using current high/low and previous high/low prices. 

For example assume on 1 January, for stock ABC, 

Day high = Rs. 100
Day low = Rs. 80
Previous high = Rs. 90
Previous low =  Rs. 83
Day high – previous high = Rs. 100 – Rs. 90 = Rs. 10 
Previous low – current low = Rs. 83 – Rs. 80 = Rs. 3 

Since Rs. 10 > Rs. 3, DM is positive and the vice versa would result in -DM 

Similarly, for ADX 14, the sum of 14-day TR is obtained.

Once DM is calculated, DI is derived from it. 
Now DX is calculated as = DI 14 difference/ DI 14 sum x 100 

ADX = Simple average of DX (14 day)

With charting facilities now available to investors online, just with a click, the ADX indicator can be presented on your screen. These calculations are usually only drawn on excel sheets to learn and understand ADX in depth

Trading based on ADX

If the stock price increases, DI+ crosses over DI- and ADX is greater than 20, then a buy signal is generated.

If the stock price decreases, DI- crosses over DI+ and ADX is greater than 20, then a sell signal is generated.

ADX is less than 20 indicates stock consolidation and sideways movement of stock price, i.e., it is typically range bound fluctuating between support and resistance.

Limitations of ADX

Since it’s based on moving averages, the indicator reacts slowly to any price changes. It is a lagging indicator.

ADX may not be a good indicator for less volatile stocks, and for the more volatile ones, there may be too many false signals generated.

ADX is not sufficient. It needs to be used in conjunction with other indicators for the purpose of trading.

A divergence in ADX is not indicative of a change in trend. As long as the value is above 20, the trend is unimpaired.

Conclusion

The ADX indicator not only detects trending conditions but also helps traders find the most profitable trends to trade. ADX also signals changes in trend momentum, allowing risk management to be addressed. The best returns are obtained by trading the strongest trends and avoiding range situations.

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Ayushi Mishra

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