The Average Directional Movement index (ADX) is a useful tool for the traders to gauge the strength of the trend and identify trading opportunities, says Karan Bhojwani
Regardless of whether you are a short-term trader or a long-term investor, you have probably heard the common wisdom that ‘the trend is your friend.’ Trend following remains the most absolute mainstream methodology for making huge profit in the stock markets. In the world of stock markets, there are two essential phases, namely, trending and sideways. Atrending phase can be defined as ‘a progression of rising or declining prices over any length of time’ and trend can be either uptrend or downtrend.A sideways phase is where the price shows no consistent directional bias and trades in a range.
The big question that arises is, how does a trader find out whether the price of the underlying security is trending or whether it is in a sideways phase? This special report is meant to help traders with a technical indicator that provides a consistent way to identify whether the prices are trending or not. If you are not already using the ADX, here is how you can use the average directional movement index (ADX) for gauging trend strength and finding trading opportunities.
History of ADX:
The average directional movement index is a trading technique developed by J. Welles Wilder Jr. in the 1970s that measures a trend's strength (momentum) and direction. Wilder features the Directional Movement indicators in his 1978 book, New Concepts in Technical Trading Systems. This book also includes details on Average True Range (ATR), the Parabolic SAR system and RSI. Despite being developed before the computer age, Wilder’s indicators are incredibly detailed in their calculation and have stood the test of time. The ADX Indicator:
The Average Directional Index indicator has three lines in its indicator:
1. The ADX line
2. Minus Directional Indicator (-DI)
3. Plus Directional Indicator (+DI)
The ADX line measures trend strength. A rising ADX means that the trend is gaining strength; a falling ADX shows a trend that is losing momentum or reversing, and a flat ADX shows a sideways range. What is also important to know is that the ADX is non-directional, which means that it does not give any information about the direction of the trend. When the ADX goes up, all it means is that the trend is gaining strength – this can then signal both a bullish or bearish trend.
Here is a chart which shows an excellent example of the ADX in action:
Stock Name: Indian Hotels Time scale: Daily Chart
Inputs: ADX 14 periods
Fallowing Table explain the interpretation of ADX Value
In the chart (Indian Hotels )the ADX line is the white line and when the ADX line crosses above the 20 level it is marked with black circlein the chart and we see there is a clear trend in the stock.
The second part of the ADX indicator are the two DI lines, namely, Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), which helpin identifying the direction of the trend. In general, the bulls have the edge when (+DI) is greater than (– DI), while the bears have the edge when (– DI) is greater. The crosses of these directional indicators can be combined with ADX line for a complete trading system.
The rules of using the Directional Movement are:
− Whenever the Plus DI (+DI) crosses above the Minus DI (-DI), an uptrend is said to be in place.
− Whenever the Minus DI (-DI) crosses above the Plus DI (+DI), a downtrend is said to be in place.
Following table explains how the combinations of ADX and DMI are used for entry and exit signal:
Important rules given by the famous trader and bestselling author Dr Alexander Elder in his book ‘The New Trading for A Living’:
Trade only from the long side when the positive Directional line is above the negative one. Trade only from the short side when the negative Directional line is above the positive one. The best time to trade is when the ADX is rising, showing that the dominant group is getting stronger.
When ADX declines, it shows that the market is becoming less directional. There are likely to be many whipsaws. When ADX points down, it is better not to use a trendfollowing method.
When ADX falls below both Directional lines, it identifies a flat, sleepy market. Do not use a trend-following system but get ready to trade, because major trends emerge from such lulls.
The single best signal of the Directional system comes after ADX falls below both Directional lines. The longer it stays there, the stronger the base for the next move. When ADX rallies from below both Directional lines, it shows that the market is waking up from a lull. When ADX rises by four steps (i.e., from 9 to 13) from its lowest point below both Directional lines, it “rings a bell” on a new trend. It shows that a new bull market or bear market is being born, depending on which Directional line is on top.
When ADX rallies above both Directional lines, it identifies an overheated market. When ADX turns down from above both Directional lines, it shows that the major trend has stumbled. It is a good time to take profits on a directional trade. If you trade large positions, you definitely want to take partial profits.
How to use ADX indicator effectively?
Since we are in a bull run, we have been getting a larger number of breakouts every day. However, one of the difficult steps is which breakout to trade, as we have seen that some breakouts turn out to be fake ones. So how does a trader differentiate between a strong and weak breakout?
The ADX or the Average Directional Index indicator is a handy tool that can help traders in a number of ways. For the most part, those who follow a trend trading strategy will discover that the ADX can be a useful addition
Combing price-action breakout along with ADX can maximize the chance of locating the strongest breakouts to trade.
Price breakout along with ADX rising above 20:
A Power Strategy
Combing price breakouts with ADX Indicator improves chances of success.
Step-by-step action plan:
Here’s how you can put this strategy to work in your trades:
Step 1: Look for a price pattern.It may be a symmetrical triangle pattern, ascending triangle pattern, descending triangle pattern, horizontal trend line, cup and handle pattern, rounding bottom or rounding top, etc.
Step 2: Look for ADX Line.If the ADX Line rises from low level to above 20 levels,one can initiate long at this stage as ADX line rises above 20 levels.
Step 3: You can set a recent swing low as a stop loss for the trade.
Hear is the example of this strategy
Stock Name: Reliance Industries
Breakout Pattern: Horizontal Trend Line
ADX Line: Rises from low level to above 20 levels.
In the figure (Reliance Industries), we seethat Point B is the breakout point and, at the same time, the ADX Line crosses above 20 level (20 level is marked in yellow) from the low level. Thereafter, we see that the stock has given a clear trending move.
The Core Utility Of ADX Is Highlighted Especially During High Momentum Trending Moves
What are benefits of using ADX Indicator?
ADX remains a vital tool for momentum traders as it helps them to gauge the strength and sustainability of the ongoing momentum. It’s a tool which is to be used in tandem with the ongoing established trend. The universal parameters for ADX period are 14 and 20 to guage larger degree set-ups. The core utility of the tool is highlighted especially during high momentum trending moves, when most of the directional indicators start flattening and reach their optimum threshold levels.
As a trend follower, what is the key reading to watch out on ADX Indicator?
Depending on the style of trading, one can customize the input parameters within this oscillator. For example, a short term trader could use ADX 9 which could help him catch the expected momentum at a very nascent stage. The evaluation is primarily done on the basis of the ADX line itself when it starts moving towards 25 zone from below and its +DI line is quoting
Illustration Number 2
Stock Name: Rain Industries
Time Scale: Weekly
Breakout Pattern: Triangle-Like
ADX Line: Rises from low level to above 20 levels.
In the figure (Rain Industries), after the stock witnessed triangle-like pattern and the ADX Line crossed above the 20 level (20 level is marked in yellow) from the low level, we see that the stock has moved in a clear uptrend. above the same, which usually translates into a momentum building scenario on the positive side in tandem with the ongoing bullish trend. Another famous approach is the convergence of the +DI and -DI lines near a certain zone, which could be deceptive due to its subjectivity in reading the confluence zone and the degree of ascent or decent in both the averages.
How can a day trader use ADX indicator to his advantage and what is an ideal setting (period setting) for ADX indicator to be used by a day trader?
As discussed above, the momentum traders could use the combination of ADX period 9, which could help them gauge the upcoming momentum or an amplified move well in advance. Since it’s a trend following tool, contra signals should be avoided as the rate of failure is high. Traders should try to enter the momentum when the ADX line moves above 25 and hold positions until 45-50 zone is sustained.
Holy Grail Pattern
There is no ‘Holy Grail’ in stock markets. The Holy Grail is, of course, not the Holy Grail. Linda Bradford Raschke and Larry Connors named it so for its simplicity. As both of them are prominent traders, this trading strategy is hugely popular.
Step-by-step description of Holy Grail Pattern:
Buy rules (Sell rules are reverse)
1. The 14-period ADX must initially be greater than 30 and rising.
2. Look for a retracement in price to the 20-period exponential moving average. This will usually be accompanied by a turndown in the ADX.
3. When the price touches the 20-period moving average, put a buy stop above the high of the previous bar.
4. Once filled, enter a protective sell stop at the newly formed swing low. Trail stops as profits grow.
Example of this set-up
Stock Name:Trigyn Technologies
Time Scale: Daily
In the chart, we see that after the stock made a high of `146.75, the stock pulled back to re-test its 20-day EMA and, at this point, the ADX Line was greater than 30 and rising.So this qualifies to be called the strategy of ‘Holy Grail Pattern’ as mentioned by Linda Bradford Raschke and Larry Connors as the stock has seen a good uptrend from thereon.
Sameet Chavan, Chief Analyst, Technicals and Derivatives
ADX Of 14-Period Can Be Used For Better Signals
Why use ADX indicator?
ADX (Average Directional Index) is a trend following indicator and it helps in finding the strength of the trend, rather than identifying the trend. Many times, false signals or breakouts/ breakdowns occur in the markets and ADX values can help us in identifying them to some extent.
How to read ADX Indicator?
— ADX range between 0-20 is considered as weak trend and prices may trade range-bound during this phase.
— ADX above 25 indicates that the trend is developing
— ADX readings between 30-50 indicate a strong trend and an ideal time for momentum traders to participate.
— ADX falling from higher levels (50) is a sign of consolidation.
— ADX reading above 50 is hardly seen, however, it indicates a matured trend and may see the trend coming to an end and prices re-entering the trading range.
But, it should be used in conjunction with other two key components, mainly +ve DI and –ve DI. ADX readings represent uptrend if +ve DI is trading above -ve DI and vice versa.
For e.g. if ADX rises above 30 with +DI above -DI, it indicates that the uptrend is getting stronger. Similarly if ADX rises above 30 with -DI above +DI, it is an indication that the downtrend is likely to reinforce.
How to use ADX Indicator for day trading?
A trader can use ADX to recognize the strength of the trend, and based on the reading, he can use suitable indicators to trade for sideways or trending markets.
If the ADX levels are in the range of 10–25, the trend is likely to be sideways and the trader can take benefit of range trading with the help of Bollinger band, reversal candlestick patterns on crucial support and resistance zones.
If the ADX levels are placed in the range of 30-50, the trend is likely to be strong and traders can trade based on breakout/breakdown set-ups and also with the help of moving average crossovers.
ADX of 14-period can be used for better signals.
However, we believe that this tool should not be used by the day trader as the strength of the trend cannot be gauged in the limited time period. A day trader can analyse it on the daily time frame and then, by using other momentum oscillators on intra-day charts, one can take a better trading decision.
Chief Strategist – Technical Research & Trading Advisory, Chartviewindia.in
"Traders should understand that in technical analysis, the decisions have to be taken based on weight of technical evidence, but not in isolation based on a single indicator. In other words, they should take decisions based on what majority of indicators are pointing out (let us say 3 out of 5)"
Step-by-step description of EMA crossover strategy
Step 1: Use the daily time frame, or a shorter time frame, although the former may yield better results. It includes the combination of two EMAs—a 3-period and a 10-period—coupledwith a 14-period Average Directional Movement Index with positive and negative directional indicators (+DI and –DI).
Step 2: +DI line is above the –DI line and the ADX line is above the 25 level.
Step 3: When 3-day EMA crosses above 10-day EMA.
Step 4: Exit signal is generated when the 3-day EMA crosses back to the 10-day EMA. Alternatively, you can use a trailing stop based on percentage.
Armed with the Average Directional Index (ADX) tool, a trader can make huge improvement on his/her buying or selling decision, the latter in case you are comfortable selling short. The two most valuable advantages of utilising ADX are: it helps you to determine if price is trending or not and it helps trader to be out of the false moves and whipsaws in the market that have been witnessed quite a lot lately. But a word of caution: there are big advantages that go with the strategy, but there are some disadvantages of this indicator as well.There is no Holy Grail indicator that is fail-proof, hence, traders are advised to use the ADX in conjunction with other technical patterns and indicators.