One of the most accurate indicators used in trading to book more profits is ADX or  Average Directional Index. 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.

What Is the Average Directional Index (ADX)?

When the line is falling, trend strength is decreasing, and the price enters a period of retracement or consolidation. ADX fluctuates from 0 to 100, with readings below 20 indicating a weak trend and readings above 50 signaling a strong trend. As we mentioned earlier in the article, ADX can be used not only in trend following strategies but also in mean reversion, to define oversold conditions that are worth acting on. In those cases, the role of the ADX shifts from a being a tool that tells us when market strength is worth acting on, to one that shows when it has moved too far in one direction. Many traders want to know the best settings for their particular indicator.

What is ADX indicator and how to use it in Trading

It’s important to understand the effects of all the smoothing involved in the ADX, +DI and -DI calculations. Because of Wilder’s smoothing techniques, it can take around 150 periods of data to get true ADX values. Wilder uses similar smoothing techniques with his RSI and Average True Range calculations. ADX values using only 30 periods of historical data will not match ADX values using 150 periods of historical data. Smoothed versions of +DM and -DM are divided by a smoothed version of the Average True Range to reflect the true magnitude of the move. Integrating these advanced ADX concepts into your analytical toolkit can enhance your understanding of market dynamics and make more informed trading decisions.

What are the optimal settings for the ADX indicator on a 5-minute chart?

Moreover, a strong ADX trend may provide the confidence to allocate more money to a position, adjusting risk management parameters accordingly. The maximum drawdown was -62%, with a Sharpe Ratio of 0.6 and a Calmar Ratio of 0.19. Volatility was 19%, with 121,452 trades, 3,641 positive days, and 3,071 negative days. Values below 20 often indicate a weak or non-existent trend, while values above 40 suggest a strong trend. Understanding how to interpret the values of the ADX indicator can significantly enhance your trading strategy. Adx indicator on alone does not signify whether the trend is Uptrend or Trend is Downtrend.

According to our in-depth testing, an ADX(DMI + 14) setting crossing above 20 is a profitable buy signal, and crossing below 20 is a reliable sell signal. These settings resulted in an ADX 28% outperformance versus the S&P 500 stocks. Do you want to test any indicator, chart pattern, or performance for any US stock? Our Trendspider review unveils insights into discovering the most powerful trading strategy development and testing service. Interpreting the ADX in conjunction with +DI and -DI provides a clearer picture of trend strength and direction.

As such, the ADX is essentially the smoothed average of the DX, giving you a clearer view of trend strength. Utilizing ADX alongside +DI and -DI can help you discern trend stability and strength more effectively. Effective money management and risk assessment involve ADX as a gauge for placing stop losses. Should the ADX trend weaken, tightening your stop loss could protect your capital.

Most of the time we find that the 14-period IS NOT optimal and decide to go with settings as low as 3 up to perhaps 30 at the most. Since ADX is non-directional, this shows the reversal is as strong as the prior trend. Traders may find readings other than 25 are better suited to indicate a strong trend in certain markets. The Average Directional Index (ADX) is in turn derived from the smoothed averages of the difference between +DI and -DI; it measures the strength of the trend (regardless of direction) over time. Positive and negative directional movement form the backbone of the Directional Movement System. Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between their respective highs.

This allows you to view broader market trends and make more informed decisions. Conversely, an hourly or 4-hour chart may provide the immediate detail you need for shorter-term trading to spot quicker trend changes. The formula to calculate the final ADX value is an intricate process. Still, it effectively provides a single line, typically plotted alongside the +DI and -DI, to indicate how strong or weak a trend is. A high ADX value signifies a strong trend, while a low ADX value can indicate a weak trend or a non-trending market. Traders use the ADX to determine whether a market is trending and gauge the strength of that trend.

  1. TrendSpider gets my vote for the best backtesting software for retail investors.
  2. To calculate the ADX, determine the + and – directional movement (DM).
  3. If ADX is above 23  and the +DMI line moves downwards, which is from above to below the -DMI line then this indicates a sell signal.
  4. Similarly, the ADX may not be suitable for instruments with low trading volume, as the ADX is based on the number of price changes, which may be limited in such cases.

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. After all, the trend may be your friend, but it sure helps to know who your friends are.

Traders can also use oscillators to understand price movements and market momentum. One potential pitfall is that the ADX can be misleading in choppy or ranging markets. The ADX is designed to measure trend strength, so it may not provide accurate readings in a market that is not trending. In such cases, the ADX may oscillate around a certain level, which could give false signals to traders.

The calculation example below is based on a 14-period indicator setting, as recommended by Wilder. Directional movement is negative (minus) when the prior low minus the current low is greater than the current high minus the prior high. This so-called how to use adx indicator Minus Directional Movement (-DM) equals the prior low minus the current low, provided it is positive. Directional movement is positive (plus) when the current high minus the prior high is greater than the prior low minus the current low.

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. The next time you think a trend is changing and you need to decide whether to stick to this “friend” or cut ties, consider trying the ADX to confirm the trend’s strength. When the ADX has risen above 50, this indicates that the price has picked up momentum in one direction.

The indicator can’t predict a trend will continue, only that the security trended recently. The ADX measures the strength of a trend but does not predict its direction. The ADX simplifies the information given by Aroon’s complex time-based inputs into a single line trending within a zero to 100 range, making it possible to view trend strength more directly. Your decision-making might involve Aroon for timing and ADX for confirming the trend’s persistence.

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