All you wanted to know about the ADX indicator

The Average Direction Index (ADX) is a widely used technical analysis indicator that helps one gauge the strength of a trend, be it upward or downward. It determines the core strength of a trend. The ADX is derived from two accompanying indicators, known as the Positive Directional Indicator (+D) and the negative Directional Indicator (-D). Therefore an ADX indicator has three lines on the chart: +D,-D, and the ADX line.

The indicator was developed by Welles Wilder for the commodity chart, but due to its high relevance and competence, it is now used in other markets as well.  '+D' and '–D' show the movement of a stock -- +D means the price is moving up, and vice versa. This also helps one identify whether the bulls or bears are gaining the hold on the markets.

The ADX is plotted on the scale of 0-100 and whenever the value is above 25, the trend is said to be carrying strength. The direction of the ADX also plays a crucial role. A rising ADX from below 25 value indicates a stronger strength that may see a consistent rise going forward. When ADX stays below 25, the trend is likely to remain weak and the stock may see consolidation or sideways movement. Similarly, when the ADX starts to fall from higher levels, the stock's strength starts to diminish gradually. CLICK HERE FOR THE CHART

How to trade with the ADX indicator?

· Whenever a stock gives a breakout while the ADX is nearing 25 value, it provides higher returns as the strength starts to rise.

· Avoid a stock when the ADX direction is downward

· At the time when +D and –D make a positive crossover, having ADX around 40-50 range delivers decent upside in a stock.

· An ADX making a reversal after falling from higher levels, suggests a scenario of regaining strength on corrective moves.

· Intra-day momentum may see a lag in ADX, so higher time frames are suitable.  

Identification of the strength of a trend

ADX value -- 0-25

Strength of a trend -- Absent or Weak Trend

ADX value -- 25-50

Strength of a trend -- Strong Trend

ADX value -- 50-75

Strength of a trend -- Very Strong Trend

ADX value -- 75-100

Strength of a trend -- Extremely Strong Trend

When ADX is in the range of 25-50, several chart patterns have given astonishing returns. This range indicates the beginning of a strength that will get stronger as the value starts scaling higher and so does the price. Between 50-75 values, the strength sees follow-up buying that makes the strength firmer and the corrective moves witness buying momentum.

Although the strength is very extreme around 75 -100 values, stocks start to witness profit booking, inevitably. This normally suggests that the price has reached the extreme point wherein it starts to show weakness.

ADX has a strong significance from a long-term perspective. However, recent years have seen traders using it for a short-to-medium term perspective. One way to manage ADX is to correlate the daily and weekly chart for better strength confirmation.

Of late, the philosophy of drawing a trendline on ADX has also been very effective. A trendline breakout or formations like 'double bottom' or 'Inverse head and shoulder', etc. have been effective in gauging the strength of a trend.