How to use ADX (Average Directional Index) Indicator in Trading Strategy?
When investing in the stock market, you need to identify a strong trend in a stock’s price movement. The ADX indicator or Average Directional Index is one such indicator that helps in identifying the strength of a market trend. Riding on this trend, you can make attractive returns. Moreover, you can sell off your stocks and minimise losses when identifying a downtrend.
Let’s understand the ADX indicator in detail.
What is an ADX Indicator?
Developed by J. Welles Wilder, the ADX indicator, which stands for Average Directional Index, is a technical indicator that indicates the strength of a trend. The trend might be an upward trend or a downward one. The indicator measures whether the price of a stock is in the trading or non-trading movement. Compared to the RSI (Relative Strength Indicator), the ADX does not depict a bull or bear market. Instead, it measures how strong the current price trend is.
How Does an ADX Trend Indicator Work?
The Average Directional Index Indicator is drawn as a straight line starting from 0 and ending on 100. If the trend is strong, the indicator rises and if the trend is negative, the indicator falls.
Usually, an indicator reading below 20 is considered to be a low trend wherein the price of a stock is not rising. On the contrary, a reading above 50 indicates a strong trend. It shows that the stock price is rising with a positive momentum.
Also Read: Understanding Wholesale Price Index
How is an ADX Indicator Built?
To construct an ADX Indicator, you need three main inputs, the Plus Directional Movement Index, also called (DI+) or (+DI), and the Minus Directional Movement Index, also called the (DI-) or (-DI) and the ADX line. These inputs are calculated as follows –
- If the difference between the current and prior high in the stock price is greater than the difference between the current and prior lows, you get a DI+ value. If, however, the difference is negative, the DI+ value is zero.
- The DI- value is generated if the difference between the current and prior low in the stock price is greater than the difference between the current and prior highs. If the difference is negative, the DI- value is zero.
- The DI+ and DI- values are plotted in a line graph to generate the DI line.
- The ADX line is generated by calculating the smoothed average of the difference between the DI+ and DI- lines.
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How to Calculate ADX?
To calculate the ADX, there are different calculations that you have to do. These are as follows –
- The DI+ calculation
DI+ = {(Smoothed Moving Average + DM) / ATR} * 100
- The DI- calculation
DI- = {(Smoothed Moving Average – DM) / ATR} * 100
- The DX calculation
DX = {(DI+ – DI-) / (DI+ + DI-)} * 100
Once you have all these values, the ADX indicator formula can be calculated as below –
Initial ADX = the sum of ‘n’ period of DX / n
Subsequent ADX = [{previous ADX * (n-1)} + current DX] /n
In these formulae, the values are as follows –
+DM = current high – prior high
-DM = Prior low – current low
ATR = Average True Range
N = number of periods over which you are calculating. The default period is 14 but you can change the period as per your requirements.
How to Set up the ADX Indicator?
After you use the ADX formula and the calculations are done, you would get three lines:
- The DI+ line would be a green line which would indicate a positive direction of price movement
- The DI- line would be a red line which would indicate a negative direction of price movement
- The ADX line would be black line would be a non-directional line starting from 0 and ending at 100
This would set up the whole ADX indicator, and you can then use the indicator to assess the trend and trade in the stock market.
How to Trade using ADX Indicators?
The Average Directional Movement Index indicator can prove very useful when trading. You can go long or short on a stock if you spot a breakout.
Alternatively, you can use the indicator to find out whether the stock price would continue following the current trend or not. If not, you can buy or sell, maximising your profits and minimise your losses.
For instance, if the ADX indicator falls below 50, the trend is losing steam. This would be the right moment for you to close any open trade and minimise losses.
You can also use the ADX indicator and another technical indicator to determine whether the trend is going upwards or downwards.
ADX Indicator Trading Strategy
The ADX indicator helps identify the support and resistance levels in stock trading. These levels are quite important as they can help you determine whether the stock price stays within the range of its trend or if there are considerable fluctuations. Using the ADX indicator, you can identify two main trading strategies:
- Checking if there can be a breakout, i.e., a sudden momentum in the price of the stock, which can happen due to high demand and supply
- Checking if the price is in a stable range
You can, then, use these strategies to buy or sell assets.
Also Read: Swing Trading – Strategies, Setups, List & Pros and Cons
How to Interpret the Trend Strength Indicator?
Interpreting the trend momentum can be easy if you learn how to read the ADX indicator values. The different readings on the ADX indicator helps you understand the trend. Have a look:
| ADX reading | Meaning |
| If the ADX value is rising | A strengthening trend |
| If the ADX value is falling | A weakening trend |
| If the ADX value is below 20 | A weak trend |
| If the ADX value is between 20 and 40 | A strong trend |
| If the ADX value is above 50 | An extreme trend |
You can use ADX peaks to find out whether the momentum is strong or weak. Higher peaks indicate a robust trend while lower peaks show a weak trend. Here are some possible points that you should keep in mind when interpreting the strength indicator –
- If the ADX indicator is more than 25, it shows a robust trend even if the peaks are low
- If the market is in an uptrend and the ADX is falling, the stock prices might continue to rise
- If the ADX is falling but the prices are rising, it means that the trend is losing its momentum
- There can be a momentum divergence when the price is reaching higher levels but the ADX is falling lower. This results in a negative divergence which signals a change in the trend momentum and a start of the non-confirmation phase
Also Read: Best Index Funds – Top 20 Index Funds in India
Final Word
The ADX indicator can be applied not only in stock trading but in commodity trading and forex too. It is a technical indicator that can be used for assessing the trend in the price of the asset.
So, when trading in stocks, currencies or commodities, use the indicator and find out when to invest, when to exit and when to go long on your trade. Use the indicator with other technical indicators to get effective trading strategies that would help you get attractive returns on investment and minimise the risk potential.
FAQs on ADX Indicator
Ans. The ADX indicator signals the right time to enter or exit the market. This helps you make the right trading decisions.
Ans. The RSI indicator, when combined with the ADX indicator proves quite useful. While the ADX indicator can measure the trend momentum, the RSI indicator can help you point the right time to enter or exit the market. In the case of a downtrend, an RSI reading below 30 confirms the downtrend which signals an exit from the market. The contrary is true if the RSI reading is above 70. It indicates an uptrend signalling entry into the market.
Ans. Yes, the ADX indicator has its own share of limitations too. These limitations are as follows –
• The indicator is a lag indicator which means that it gives an indication after the trend has already started. Thus, you lose out on early emerging trends
• In the case of slow-moving or volatile stocks, the indicator might not give the right signal
• In some cases, the DI+ and the DI- lines can cross frequently. This can lead to false signals
• The ADX indicator strategy works well only when combined with other technical indicators. Independently, the indicator might not give fruitful signals
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
