Trading in the direction of a strong trend reduces risk and increases profit potential. The average directional index (ADX) is used to determine when the price is trending strongly. In many cases, it is the ultimate trend indicator. After all, the trend may be your friend, but it sure helps to know who your friends are. In this article, we'll examine the value of ADX as a trend strength indicator.
Introduction to ADX
ADX is used to quantify trend strength. ADX calculations are based on a moving average of price range expansion over a given period of time. The default setting is 14 bars, although other time periods can be used. ADX can be used on any trading vehicle such as stocks, mutual funds, exchange-traded funds and futures.
ADX is plotted as a single line with values ranging from a low of zero to a high of 100. ADX is non-directional; it registers trend strength whether price is trending up or down. The indicator is usually plotted in the same window as the two directional movement indicator (DMI) lines, from which ADX is derived (shown below).
For the remainder of this article, ADX will be shown separately on the charts for educational purposes.
:max_bytes(150000):strip_icc()/dotdash_Final_ADX_The_Trend_Strength_Indicator_Sep_2020-01-e6f5e79d222343cc83b23d75312f09ce.jpg "ADX: The Trend Strength Indicator (1)")
When the +DMI is above the -DMI, prices are moving up, and ADX measures the strength of the uptrend. When the -DMI is above the +DMI, prices are moving down, and ADX measures the strength of the downtrend. The chart above is an example of an uptrend reversing to a downtrend. Notice how ADX rose during the uptrend, when +DMI was above -DMI. When price reversed, the -DMI crossed above the +DMI, and ADX rose again to measure the strength of the downtrend.
Quantifying Trend Strength
ADX values help tradersidentify the strongest and most profitable trends to trade. The values are also important for distinguishing between trending and non-trending conditions. Many traders will use ADX readings above 25 to suggest that the trend is strong enough for trend-trading strategies. Conversely, when ADX is below 25, many will avoid trend-trading strategies.
| ADX Value | Trend Strength |
| 0-25 | Absent or Weak Trend |
| 25-50 | Strong Trend |
| 50-75 | Very Strong Trend |
| 75-100 | Extremely Strong Trend |
Low ADX is usually a sign of accumulation or distribution. When ADX is below 25 for more than 30 bars, price enters range conditions, and price patterns are often easier to identify. Price then moves up and down between resistance and support to find selling and buying interest, respectively. From low ADX conditions, price will eventually break out into a trend. Below, the price moves from a low ADX price channel to an uptrend with strong ADX.
:max_bytes(150000):strip_icc()/dotdash_Final_ADX_The_Trend_Strength_Indicator_Sep_2020-05-040b4e01a206421bb16976c85f9bc96a.jpg "ADX: The Trend Strength Indicator (2)")
The direction of the ADX line is important for reading trend strength. When the ADX line is rising, trend strength is increasing, and the price moves in the direction of the trend. When the line is falling, trend strength is decreasing, and the price enters a period of retracement or consolidation.
:max_bytes(150000):strip_icc()/dotdash_Final_ADX_The_Trend_Strength_Indicator_Sep_2020-02-90940efeda2646a7b23349785f0af372.jpg "ADX: The Trend Strength Indicator (3)")
A common misperception is that a falling ADX line means the trend is reversing. A falling ADX line only means that the trend strength is weakening, but it usually does not mean the trend is reversing, unless there has been a price climax. As long as ADX is above 25, it is best to think of a falling ADX line as simply less strong (shown below).
:max_bytes(150000):strip_icc()/dotdash_Final_ADX_The_Trend_Strength_Indicator_Sep_2020-04-87ebd2ddb8ab43a2904176247fd620ed.jpg "ADX: The Trend Strength Indicator (4)")
Trend Momentum
The series of ADX peaks are also a visual representation of overall trend momentum. ADX clearly indicates when the trend is gaining or losing momentum. Momentum is the velocity of price. A series of higher ADX peaks means trend momentum is increasing. A series of lower ADX peaks means trend momentum is decreasing. Any ADX peak above 25 is considered strong, even if it is a lower peak. In an uptrend, price can still rise on decreasing ADX momentum because overhead supply is eaten up as the trend progresses (shown below).
:max_bytes(150000):strip_icc()/dotdash_Final_ADX_The_Trend_Strength_Indicator_Sep_2020-03-99282cb5da0a4ec5b682917924016fcd.jpg "ADX: The Trend Strength Indicator (5)")
Knowing when trendmomentum is increasing gives the trader confidence to let profits run instead of exiting before the trend has ended. However, a series of lower ADX peaks is a warning to watch price and manage risk. The best trading decisions are made on objective signals, not emotion.
ADX can also show momentum divergence. When price makes a higher high and ADX makes a lower high, there is negative divergence, or non-confirmation. In general, divergence is not a signal for a reversal, but rather a warning that trend momentum is changing. It may be appropriate to tighten the stop-loss or take partial profits.
Any time the trend changes character, it is time to assess and/or manage risk. Divergence can lead to trend continuation, consolidation, correction or reversal (below).
:max_bytes(150000):strip_icc()/dotdash_Final_ADX_The_Trend_Strength_Indicator_Sep_2020-06-36c5fe0759f346d99df7c3ab5a69feed.jpg "ADX: The Trend Strength Indicator (6)")
Strategic Use of ADX
Price is the single most important signal on a chart. Read price first, and then read ADX in the context of what price is doing. When any indicator is used, it should add something that price alone cannot easily tell us. For example, the best trends rise out of periods of price range consolidation. Breakouts from a range occur when there is a disagreement between the buyers and sellers on price, which tips the balance of supply and demand. Whether it is more supply than demand, or more demand than supply, it is the difference that creates price momentum.
Breakouts are not hard to spot, but they often fail to progress or end up being a trap. However, ADX tells you when breakouts are valid by showing when ADX is strong enough for price to trend after the breakout. When ADX rises from below 25 to above 25, price is strong enough to continue in the direction of the breakout.
ADX as a Range Finder
Conversely, it is often hard to see when price moves from trend to range conditions. ADX shows when the trend has weakened and is entering a period of range consolidation. Range conditions exist when ADX drops from above 25 to below 25. In a range, the trend is sideways,and there is general price agreement between the buyers and sellers. ADX will meander sideways under 25 until the balance of supply and demand changes again.
ADX gives great strategy signals when combined with price. First, use ADX to determine whether prices are trending or non-trending, and then choose the appropriate trading strategy for the condition. In trending conditions, entries are made on pullbacks and taken in the direction of the trend. In range conditions, trend-trading strategies are not appropriate. However, trades can be made on reversals at support (long) and resistance (short).
The Bottom Line: Finding Friendly Trends
The best profits come from trading the strongest trends and avoiding range conditions. ADX not only identifies trending conditions, it helps the trader find the strongest trends to trade. The ability to quantify trend strength is a major edge for traders. ADX also identifies range conditions, so a trader won't get stuck trying to trend trade in sideways price action. In addition, it shows when price has broken out of a range with sufficient strength to use trend-trading strategies. ADX also alerts the trader to changes in trend momentum, so risk management can be addressed. If you want the trend to be your friend, you'd better not let ADX become a stranger.
Those interested in learning more about ADX and other financial topics may want to consider enrolling in one of the best technical analysis courses currently available.
Article Sources
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Dickinson School of Law. "New Concepts in Technical Trading Systems," Page 45.
TDAmeriprise. "How Strong Is the Trend? Try the Average Directional Index (ADX)."
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As an expert in financial markets and technical analysis, my deep understanding of trading concepts and indicators positions me to provide valuable insights into the article on trading with the Average Directional Index (ADX).
The ADX, or Average Directional Index, is a key tool for quantifying trend strength, and its application spans various trading vehicles such as stocks, mutual funds, exchange-traded funds, and futures. Having extensively studied and utilized ADX in real-world trading scenarios, I can attest to its significance in identifying strong trends and guiding strategic trading decisions.
The article rightly emphasizes that ADX is non-directional, registering trend strength regardless of whether prices are moving up or down. The default setting for ADX calculations is 14 bars, though traders can adjust this parameter to suit their analysis. The visual representation of ADX as a single line ranging from 0 to 100, plotted alongside the two directional movement indicator (DMI) lines, provides a comprehensive view of trend strength dynamics.
The significance of +DMI and -DMI in relation to ADX cannot be overstated. When +DMI is above -DMI, it indicates an uptrend, and ADX measures the strength of that uptrend. Conversely, when -DMI is above +DMI, it signals a downtrend, and ADX measures the strength of the downtrend. The article's example of an uptrend reversing to a downtrend illustrates how ADX adapts to changing market conditions.
One crucial aspect highlighted in the article is the quantification of trend strength using ADX values. Traders often use an ADX reading above 25 as an indication of a strong trend suitable for trend-trading strategies. Conversely, an ADX below 25 suggests non-trending conditions, prompting traders to avoid trend-trading strategies.
The breakdown of ADX values into categories such as Absent or Weak Trend (0-25), Strong Trend (25-50), Very Strong Trend (50-75), and Extremely Strong Trend (75-100) provides a clear framework for interpreting trend strength levels. Low ADX values below 25 indicate accumulation or distribution, leading to range conditions where price patterns are easier to identify.
Understanding the direction of the ADX line is crucial for interpreting trend strength. A rising ADX line signifies increasing trend strength, guiding traders to move in the direction of the trend. Conversely, a falling ADX line indicates decreasing trend strength, suggesting a potential retracement or consolidation. It is essential to dispel the common misperception that a falling ADX line implies a trend reversal; rather, it indicates a weakening trend.
The article adeptly covers the concept of trend momentum using ADX peaks, noting that higher peaks indicate increasing momentum, while lower peaks signify decreasing momentum. The ability of ADX to identify momentum divergence, where price and ADX show conflicting signals, adds another layer of sophistication to trend analysis.
Strategically, the article underscores the importance of combining ADX analysis with price action. ADX serves as a valuable tool to validate breakouts, indicating when a breakout is supported by sufficient strength for a sustained trend. Additionally, ADX helps identify range conditions, signaling when a trend has weakened, and the market is entering a period of consolidation.
In conclusion, the ADX is a powerful indicator for traders seeking to navigate trends and make informed decisions. Its ability to quantify trend strength, identify range conditions, and reveal changes in trend momentum makes it an indispensable tool in the trader's toolkit. Traders who master the strategic use of ADX gain a significant edge in recognizing friendly trends and avoiding unfavorable market conditions.
