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ADX Average Directional Index
However, the main purpose of the ADX is to determine whether a stock, future, or currency pair is trending or is in a trading range. Determining which mode a market is in is helpful because it can guide a trader to which other technical analysis indicators to use.
The chart contract below shows an excellent example of the ADX in action:
ADX Shows Trend Strength
The first concept to remember is that the direction that the ADX moves doesn't depend upon the direction of the underlying stock. All the ADX shows is the trend strength.
- Strong upward trend of stock = Increasing ADX
- Strong downward trend = Increasing ADX
As can be referenced from the chart of the E-mini Russell 2000 Index Futures contract above, when the e-mini future was rising in a strong upward trend, the ADX indicator was rising.
When the e-mini futures contract moved into a non-directional consolidation phase, the ADX decreased.
ADX is a Great Complement to Other Technical Indicators
The ADX is so popular because determining whether a stock, commodity, or currency market is trending or not trending can help a trader avoid the pitfalls of some indicators.
Moving Averages
Moving averages and their variants are effective during trending markets; however, during consolidation periods when prices go up and down, but in no direction, moving average indicators have a tendency to give numerous false buy and sell signals that add up to trading losses. During trending markets, use moving averages, trend-lines, and other trend following technical indicators.
Oscillators
Oscillators are extremely effective in non-trending markets. Buying low and selling high is accomplished quite readily with oscillators. Unfortunately, during trending markets, oscillators perform quite poorly, often selling short during a bull market run or buying during a bear market downtrend, adding up to large losses. For periods of non-trending, use oscillators like Stochastic Fast & Slow, RSI, or Williams %R and other range-bound indicators like Bollinger Bands or Moving Average Envelopes.
The importance of the 20-level and 40-level, along with more examples of the ADX in action,
Interpreting the ADX
It is important to re-emphasize that the direction of price doesn't affect the ADX; it is the strength of the stock, futures, or currency's trend that matters.
Below, we see the contract chart , but here the e-mini future is in a downtrend, a strong downtrend. Note that the ADX is rising even though the price of the contact is falling.
Interpreting the ADX
- Below 20: Non-trending market.
- Crosses above 20: Signal that a trend might be emerging; consider initiating buy or sell short in direction of prevailing stock, future, or currency price movement.
- Between 20 & 40: If ADX is increasing between 20 and 40, then it is further confirmation of emerging trend. Buy or shortsell in the direction of the current market direction. Avoid using oscillator technical indicators and use trend following indicators like moving averages.
- Above 40: Very strong trend.
- Crosses above 50: Extremely strong trend.
- Crosses above 70: "Power Trend"; very rare occurence
In his book, New Concepts in Technical Trading Concepts, Welles Wilder, Jr., the creator of the ADX also created the DMI+ and DMI- indicators to generate buy and sell signals specifically for the ADX technical analysis indicator. In fact the ADX is derived from the DMI+ and DMI- calculations (see: DMI).
