ADX (Average Directional Movement Index)

Introduction

Within the realm of stocks you’ll come across several types of trading situations. Whether it be uptrends, downtrends, reversals, divergences, and whatnot, but because of that one thing becomes apparent.

And that is that any trader who takes his work seriously would want to capitalize on those circumstances. But capitalizing on them will naturally mean that they have to identify them first. And how can they go about doing that?

The answer is indicators. Littered throughout the landscape you’ll find all sorts of indicators out there and each of them built for a specific purpose.

You have your various moving averages, like the SMA, EMA, WMA, DEMA, and more.

However what we’ll be looking at today is the ADX indicator short for the average directional index. So with that said, let’s get into it.

What is ADX (Average Directional Movement Index)?

The average directional movement index can be traced as far back as 1978 with J. Welles Wilder being the man behind its development.

Lately it has become a widely used tool by technical analysts and is available as a sort of standard within the various indicators that most trading platforms these days offer. But what is it really made for you might be wondering, i.e., its purpose? We’ll get into that below.

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The Purpose of ADX

Simply put the ADX is a technical indicator that traders use to gauge how strong the price trends really are for certain stocks or securities.

Trading within the direction of strong trends can reduce risk and raise the potential for profitability which is why traders even care about identifying trends in the first place.

Interestingly enough a lot of traders think of ADX as the ultimate indicator for trends because of its reliability.

So ADX quantifies trend strength and its calculations are based on this moving average of the price range expansion across a certain period of time.

You’ll find the default setting to be 14 bars. Still if you don’t want that you can always use other time periods.

You can use the ADX with any financial security which trades such as mutual funds, stocks, exchange traded funds, or futures, etc.

How is ADX Calculated?

Trading platforms usually do all the calculations for you. You just have to set the periods or some other settings. So you don’t really need to know how it’s calculated. But if that’s something you’re curious about then read on. If not you can just skip ahead.

ADX Calculation Steps

To calculate that ADX you’ll need to determine the – and + directional movement or DM. The -DM and +DM can be found by calculating the current low or down move minus that previous low and current high or up move minus that previous high.

If the up move is higher than that down move while being greater than zero as well then the +DM is equivalent to the up move.

Otherwise it would equal zero. But if the down move is higher than that up move while being greater than zero then the -DM will be equivalent to the down move. Otherwise it too will equal zero.

The +DI or positive directional indicator is equal to 100 times that EMA of the +DM divided by the ATR or average true range across any number of periods.

The -DI or negative directional indicator is equal to 100 times that EMA or exponential moving average of the -DM divided by that ATR.

As for the ADX itself, it equals to 100 times the EMA of that absolute value you get by calculating (+DI minus -DI) divided by (+DI plus -DI).

Key Characteristics of ADX

So based on the calculation steps we discussed the key characteristics of the ADX would have to be the positive and negative directional movement, the negative and positive directional indicators, and the EMA.

How to Use ADX in Trading

By now you might have a bit of a clue on what the ADX is supposed to be. But knowing that isn’t enough as you need to learn how to trade with it as well and this is exactly what we’ll be looking at below.

Identifying Trend Strength with ADX

The first and most apparent use case for the ADX would be assessing the strength of those trends. How you may ask? It’s simple.

You usually get some specific numbers ranging from 0 to 100 and these can represent weakening or strong trends. You can just look at those numbers to see what you’re dealing with. 

So when those ADX numbers are rising that means the trend is growing stronger. But when those numbers are declining it means the trend is growing weak.

Generally an ADX reading above 25 is supposed to represent strong trends whereas readings below 20 are usually seen as weak.

Using ADX with +DI and -DI

Also the ADX indicator is used as a sort of confirmation tool too with the positive and negative directional indicators.

So when the positive directional indicator is over the negative directional indicator it could mean that there is an uptrend in the market. What the ADX does here is simply confirm the strength of that trend like if it’s weak or not.

Trend Reversals with ADX

Then there’s also how the ADX is used to confirm reversals. The +DI and -DI lines are used here as well.

Basically when the positive line crosses over the negative one you have a bullish reversal and if the negative goes above the positive line then you get a bearish reversal.

If the ADX line is going up too with these crossovers then you may have an especially strong trend on your hands.

Confirming Breakouts with ADX

You can even use the ADX to verify breakouts. So if you see the price breaking out with the ADX reading being more than 25 then it means that the momentum in that new direction is sustainable. But you have the exact opposite if you get a breakout with an ADX reading of below 25.

ADX Strategies for Different Trading Styles

The stock trading landscape is filled with all kinds of trading styles. But the main ones you tend to see more often have the day, swing, and long-term trading. So how does the ADX relate to that? Let’s find out.

Day Trading with ADX

For the day traders whose preferences tend to lie within short term profitability they can adjust the time frames of the ADX accordingly to reflect them. Popular strategies that you often find day traders using have to be scalping, trend following, and a few others.

Swing Trading with ADX

For the swing traders since their focus tends to revolve more around medium to long term gains, they could employ lookback periods with the ADX that match that.

Reversals and confirming breakouts will manifest more due to that extra time and so any strategy that involves them may be better for you if you’re a swing trader.

Long-Term Investing with ADX

But if it’s the long term that you find more appealing then like with the day and swing traders you can change those time frames to make them a bit longer as those would generally tend to suit your goals more.

Longer time frames will give you more space to work with crossover or reversals and also divergences. 

Advantages and Limitations of ADX

As useful as the ADX may be it does have its fair share of limitations that you need to consider if you are to make the most of your time trading with this indicator.

Benefits of Using ADX

But before we get into those limitations you need to know what it gets right too. For one it’s regarded by a lot of traders to be quite reliable for what it can do, which is mainly gauging trend strength and confirming breakouts and reversals and because of that it’s also widely used. It’s flexible too as you can modify it to suit your trading requirements or style.

Limitations of ADX

ADX isn’t exactly suitable when you see prices moving sideways within a trading range. It’s a lagging indicator too since it’s based on moving averages.

Also it doesn’t really say much about a security’s actual price, just where the prices are heading towards and trend strength. So it would be wise if you just use it with other indicators if you want to determine exact exit or entry points.

Conclusion

The most profits tend to come from trading during strong trends and avoiding range conditions. With the ADX you’re not only able to find trending conditions but you’re also getting to know some of the strongest trends.

All in all if you can quantify the strength of trends you’re basically getting a major edge but only if things appear favorable that is.