Today we will talk about one of the most effective, but lesser researched, utilized and thus underrated indicator in trading i.e the ADX (Stands for Average Directional Index). I say lesser researched because, a simple glance on kindle bookstore, or any bookstore that stocks books on Technical Analysis or Trading will often have huge repertoire of books on RSI, MACD, Stochastic, Candlestick Patterns, etc but rarely would you find a book dedicated to ADX. Let us try and understand the significance of this indicator and why it should be an important tool in every trader’s arsenal.
ADX abbreviation stands for Average Directional Index. This indicator is primarily used to gauge the trend strength. All of us would have heard the clichéd maxim “Trend is your friend”, but wouldn’t it be also nice to know how reliable your friend is? You heard it right. ADX indicator helps the Trader in understanding how strong or weak the trend is and thus make a more educated guess pertaining to whether one should follow a Trend following strategy or a sideways market strategy. Active traders would well be aware that indicators like moving averages do wonderfully well in trending markets but miserably fail in the sideways market. They fail to an extent that all the money made in the trending market could very well be wiped out. Similarly one would have also observed that indicators like Bollinger Bands & RSI (overbought & oversold) do a fabulous job in a sideways market but miserably fail in a trending market. How often have you seen RSI dancing in an overbought level in a strong uptrend for an extended period of time! Similarly how often have you seen prices hugging the upper Bollinger band and continuing their upward momentum? These instances tell you that though the indicators themselves are very useful, using them in wrong market environment can clearly prove to be counterproductive. Wouldn’t it be nice to understand the market environment first and use a strategy suitable to the prevailing market environment? That’s exactly where an indicator like ADX comes in handy. Before we get into the application, lets first have a look at the basic structure of an ADX indicator.
In the above picture, the red line is the ADX line, the blue line is +DMI & the orange line is –DMI. ADX is plotted as a single line with values ranging from a low of zero to a high of 100. Beginners find this indicator confusing to digest for one simple reason. All the traditional indicators give a sense of rising prices if the indicator is moving up and falling prices if the indicator is moving down. ADX however, does not indicate the directional bias of the trend. i.e if the ADX line is sloping up it simply tells you that the underlying trend (whichever direction it may be) is strong. Following exhibit will make this clear.
Adani Enterprises – Observe the red line (ADX line) sloping up while prices moving up on the left side. In the same chart, observe the red line (ADX line) sloping up and prices moving down.
ADX is formed by combining two other indicators which are positive directional indicator (abbreviated +DI) and negative directional indicator (abbreviated -DI). Positive Directional Indicator is calculated based on differences between current high and previous high over recent trading periods. Similarly Negative Directional Indicator is calculated based on differences between current low and previous low over certain recent trading periods. To put it simply, when the +DMI line is above the –DMI line the trend is up and when the –DMI is above the +DMI the trend is down. There are separate trading strategies which deal with buying and selling based on these +DMI and -DMI crossovers. However, we would consider it as a low probability idea, mainly because these crossovers may prove to be futile when markets get stuck in a range.
Rather, a very effective way of using this indicator would be to observe the slope of ADX itself. Following are the broad guidelines for reading the ADX slope–
- If ADX is crossing above 25 and importantly sloping up, the inference is, underlying trend has started to pick up steam. Although there is no sacrosanct number, but generally this trend will start to mature on ADX crossing above 70. In layman terms, when the ADX is starting to move just above 25, a Trader would say the Car has fully filled tank and has enough petrol to move up. When ADX starts to move above 70, the momentum may be waning as the petrol levels would now be receding.
- If ADX is sloping down from above and moving below 25, the inference is the underlying trend is turning sideways. One would expect the stock to consolidate or remain range bound, all the way till ADX slips below 10 and starts sloping up again (Exhibit 2).
- If prices are moving up, but the ADX slope instead of moving up, is moving down, it indicates a “negative divergence” and the inference is, underlying uptrend is about to reverse sooner than later.
HDFC Bank – ADX sloping below 25, stock stuck in a sideways range.
Maruti – Example where the stock kept on moving up, without ADX support.
Key Takeaways for Traders
- Stocks having a rising ADX slope above 25 are expected to show strong trend strength. Use indicators and strategies suitable for trending markets like, Moving Average crossovers, Super Trend, Trend line support or resistance and avoid indicators and strategies of sideways markets like Bollinger Bands, RSI, stochastics, etc.
- Stocks having a falling ADX slope below 25 are expected to show weak/lackluster or sideways movement. Use indicators and strategies suitable for sideways markets like Bollinger Bands, overbought and oversold RSI, Stochastics and avoid indicators and strategies of trending markets
- If there is a clear cut divergence between price and ADX , look forward book profits before the trend start to reverse.
- Option Traders can focus on directional trading strategies when ADX slope is rising and gaining momentum, whereas non-directional trading strategies when ADX slope is moving down and trend is weakening.
We hope you enjoyed these insights on ADX and would highly encourage trying and applying this indicator on your charting platforms!
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