Average Directional Movement Index: Here’s all you need to know about it
As any seasoned trader will tell you, when you trade in the direction of strong trends your chances of making a profit increase and the risk factor is diminished. ADX (average directional movement index) is useful in the determination of when the price trends strongly. It was created by J. Welles Wilder Jr. for calculating the daily charts for commodities, but it has proven to be extremely useful in other time periods and other markets.
In some cases, it is the ultimate indicator of market trends. After all, it might seem like the trend is in your favour, but it helps to understand why and how it favours you. So, read on to know more about how ADX and its values affect your chances of being a successful trader.
So, what is ADX?
As mentioned earlier, the average directional movement index is basically used for quantifying the strength of a trend. The calculations of ADX are based on the moving average of the expansions of a price range over a particular time period. The default setting for it is at fourteen bars, though you can use other periods of time, as per your needs. ADX can be useful for a variety of trading vehicles such as futures, exchange-traded funds, mutual funds, and stocks.
ADX can be plotted as a single line, having values that range from as low as zero to as high as one hundred. It is non-directional by nature. It helps in registering the strength of the trend according to whether the price is trending down or up. The indicator usually gets plotted in the same window, like the two DMI (directional movement indicator) lines, from which the average directional movement index is derived.
When the -DMI is over the +DMI, the prices are moving down, and the ADX is used for measuring the strength of that downtrend. Similarly, When the +DMI is over the -DMI, the prices are moving up, and the ADX is used for measuring the strength of that uptrend. You will see several ADX charts where the uptrend has reversed to a downtrend in a matter of a year.
The difference between the Aroon Indicator and Average Directional Index
The Aroon Indicator is also a technical indicator, which is used for identifying changes in the trend of the prices of the assets and the strength of the trend. However, there are a couple of differences between the Aroon Indicator and the ADX Indicator.
Firstly, the ADX Indicator has three lines in total, whereas the Aroon Indicator has two lines in total. Secondly, the calculations for these indexes are completely different from each other.
With that being said, it is not as though there are no similarities between the two. These two indicators are highly similar in the fact that they both come with lines that represent negative and positive movements that help in the identification of the direction of the trend. The average directional movement index helps in the determination of the strength of the trend in the same way that the Aroon Indicator does. It is very common to see the crossovers on each of these indicators at different points in time.
The different aspects of the Average Directional Index
- The trend strength
The values of ADX help the traders to identify the most profitable and the strongest trends where they can invest. These values also come in handy when there is a need to distinguish between non-trending and trending conditions. Many of the traders utilise the ADX readings of over twenty-five for suggesting when the trend is robust enough for setting trading strategies based on it. In a similar way, many of the traders utilise the ADX readings of below twenty-five for suggesting when the trend is weak for setting trading strategies based on it.
In terms of the relationship between trend strength and average directional movement index value, a value of 0 to 25 means a weak or absent trend; a value of 25 to 50 means a strong trend; 50 to 75 means a very strong trend; and 75 to 100 means a highly strong trend.
Low values of ADX are generally a sign of distribution or accumulation. When the values hit below twenty-five for more than thirty bars, the price goes into range conditions, and the price patterns often become really easy to identify. In such cases, the price ends up moving up and down between support and resistance to help in respectively finding buying and selling interests. The prices will gradually break out in the trend from low ADX conditions.
Reading the strength of the trend is also possible from the direction that the ADX line takes. When the line sees a rise, the strength of the trend is increasing and the price, naturally, moves in the direction of that trend. When the line falls, there is a decrease in the trend strength, and, in terms of the price, it goes into a period of consolidation or retracement.
A widely held misconception is that the falling average directional movement index line is an indicator of a trend reversal. The fact of the matter is that the falling line is only an indicator that the strength of the trend is weak, but that is no reason to think that the trend is seeing a reversal. Such a reversal can only occur when there is a price climax. When the value of ADX is over twenty-five, just think of the falling line as an indication of a trend that is simply not as strong as expected.
- The trend momentum
Now that the trend strength has been explained, let’s move on to the details of the trend momentum.
Having a series of average directional movement index peaks also offers a clear picture of the overall momentum of the trend. ADX also helps in providing a clear picture of when the trend is losing or gaining momentum, which is a measure of the velocity of the price. If you note that there is a series of peaks in the ADX line, then you can safely assume that the momentum of the trend is increasing.
A series of low peaks in the average directional movement index line indicates that the momentum of the trend is decreasing. A peak of over twenty-five is known as strong, even when there is a low peak. In situations of an upward going trend, the prices are able to rise on the decreasing ADX momentum, as the overhead supply gets destroyed as the trend keeps on progressing.
The main benefit of knowing the trend momentum is that the trader gets the confidence to let the profits flow while the trend momentum is on the rise, instead of taking an exit long before the trend ends. However, when there is a series of low ADX peaks, it is a warning sign to watch out for the prices and managing the risk. After all, the best decisions in trading need to be based on practical signals, and there is no scope for you to let your emotions get the better of you.
There is also something called momentum divergence, and the average directional movement index gives an indication of that. When the prices hit a higher level and the ADX is still low, the situation is called non-confirmation or negative divergence. However, this divergence is not an indication for a trend reversal in general, but more of a warning that the momentum of the trend is changing. In situations like this, you should either think about taking partial profits or tightening the stop-loss.
To sum it up, any time you see the trend changing character, get to assessing and managing the risks. Divergence can end up in trend reversal, correction, consolidation, or continuation.
The strategic uses of ADX
If you think of the most vital signal on an average directional movement index chart, it is definitely the price. You will have to know the price first and then read the entire ADX chart to understand what that price is doing. When you use an indicator to understand the market, it needs to add something more that you can’t understand from knowing the price alone.
For instance, the best of trends arises during periods when there is a consolidation of the price range. Breakouts from the range are a common occurrence in case there are disagreements between the sellers and buyers on price, which completely change the balance of demand and supply. It can be more demand/less supply and vice versa. The difference between the two is what leads to the price momentum.
Breakouts are not that difficult to identify, but the problem is that they frequently end up being a trap or they fail to go ahead. However, if you see that the ADX values are strong and the prices are trending after the breakout, then you can be well-assured that the breakout is valid. ADX values of over or below twenty-five mean that there is a good chance for the price to continue in the breakout’s direction.
- Finding the range
On the other hand, it is usually very difficult to pinpoint when the price moves to range from trending conditions. ADX indicates the weakening of trend and the signs of the market going into a range consolidation phase. The range conditions are present when the average directional movement index ends up dropping from over twenty-five to below twenty-five. The trend goes sideways in the case of a price range condition and the sellers and buyers reach a general price agreement. If the balance between demand and supply remains unchanged, ADX will continue moving sideways below twenty-five.
When combined with price, ADX can be used for getting strategy signals. Use the average directional movement index for determining if the prices are non-trending or trending, and select the right trading strategy according to the condition. In the trending conditions, the entries are done based on pullbacks and they take the direction of the present trend. The trending trade strategies are not suitable in the range conditions, but you can make trades on reversals with resistance for the short term and support for the long term.
The ADX advantage over other technical indicators
The popularity of average directional movement index stems from the fact that in terms of figuring out if a commodity, stock, or currency market is trending or not trending, it can lead a trader to avoid the drawbacks of some indicators.
Moving average is effective when the market is trending. However, during the times of consolidation, when the prices fluctuate but not in any direction, moving average variants tend to give out false sell and buy signals, which can drag you down in losses. Thus, relying only on the moving average is not advisable during trending markets.
As opposed to moving average, oscillators are highly effective when the market is not trending. The aim of buying at low prices and selling at higher prices can be achieved easily using oscillators in a market that is not trending. However, oscillators will not perform that well when it is a trending market. It can suggest selling low during bull markets and buying high during the bear market. This makes the average directional movement index a much more reliable indicator to begin with.
Other Wilder indicators and ADX
If you are planning to come up with a full trading strategy depending on volatility, then it will be helpful for you to consider combining other Wilder indicators as well. Some other indicators that can come in handy in this regard are Parabolic SAR and RSI.
The Parabolic SAR has a faster reaction to price movements and that makes it the best option for handling opening trade positions when combined with ADX predictions. RSI (Relative Strength Index) can also come in handy when you want to measure strength. Look at the recent trading charts that you have and compare how exiting with only ADX fares alongside exiting with a combination of SAR and RSI, and you will get a better idea of the difference it makes.
ADX and Bitcoin
With digital currencies being the latest ‘in thing’ in the trading world, this discussion can’t go anywhere without discussing their relation with ADX.
Correlation between price movements of bitcoins and the ADX is barely substantial enough to be highlighted here. You will see the price actions or pattern at the extremes at one ADX reading and the complete opposite in the next reading. This is not because there is something wrong with the indicator, but rather it is the volatility of the cryptocurrency that brings about this change.
During early 2018, getting a reading of fifteen on the ADX was a sure sign that bitcoin can break any way. However, this number went down to ten before we knew it, and as the days roll by, even this ten is offering an unstable market.
For reasons like these, it is not advisable to use average directional movement index as a way of trading bitcoins, but it would be better if you try to handle your risk by using small sizes of position and common trend lines or chart patterns for exit and entry. There is nothing to fret about. After all, one index cannot serve you for all the trading ideas, time frames, and market conditions.
Limitations associated with using the ADX
Crossovers can frequently occur. In fact, the frequency is just too much to take at times, which results in confusion, and you end up running in losses for trades that go south quickly. There are known as false signals, which are usually seen when the values hit below twenty-five. The average directional movement index ends up reaching over twenty-five in some cases, but this is not permanent and will get reversed with the price.
ADX has to be used alongside price analysis and other such indicators for controlling risk and filtering signals effectively.
The highest profits roll in when you go with the strong trends and steer clear of range conditions. ADX does not just identify the trending market conditions, but is also instrumental in helping the trader figure out the strongest trends for trading. The ability to quantify the strength of the trend gives a considerable edge to the traders.
To add to that, it helps in recognising the range conditions, which means the trader will not have to suffer from trying to trade when the price goes sideways. The traders also get to understand when the price breaks out of a range, having enough strength to apply trending trade strategies. The risk management aspect is also addressed by informing the trader about trend momentum. So, it will not be an exaggeration to say that ADX is what you need to be familiar with if you want the trends to work in your favour.