Trading in the direction of a strong trend reduces risk and increases profit potential. The average directional index (ADX) is used to determine when price is trending strongly. In many cases, it is the ultimate trend indicator. After all, the trend may be your friend, but it sure helps to know who your friends are. In this article in this article, we'll examine the value of ADX as a trend strength indicator.
Introduction to ADX ADX is used to quantify trend strength. ADX calculations are based on a moving average of price range expansion over a given period of time. The default setting is 14 bars, although other time periods can be used. ADX can be used on any trading vehicle such as stocks, mutual funds, exchange-traded funds and futures.
ADX is plotted as a single line with values ranging from a low of zero to a high of 100. ADX is non-directional; it registers trend strength whether price is trending up or down. The indicator is usually plotted in the same window as the two directional movement indicator (DMI) lines, from which ADX is derived (Figure 1).
For the remainder of this article, ADX will be shown separately on the charts for educational purposes.
Source: TDAmeritrade Strategy Desk
Figure 1: ADX is nondirectional and quantifies trend strength by rising in both uptrends and downtrends.
When the +DMI is above the -DMI, prices are moving up, and ADX measures the strength of the uptrend. When the -DMI is above the +DMI, prices are moving down, and ADX measures the strength of the downtrend.
Figure 1 is an example of an uptrend reversing to a downtrend. Notice how ADX rose during the uptrend, when +DMI was above -DMI. When price reversed, the -DMI crossed above the +DMI, and ADX rose again to measure the strength of the uptrend.
Quantifying Trend Strength ADX values help traders to identify the strongest and most profitable trends to trade. The values are also important for distinguishing between trending and non-trending conditions.
Many traders will use ADX readings above 25 to suggest that the trend's strength is strong enough for trend trading strategies.Conversely, when ADX is below 25, many will avoid trend trading strategies.
ADX Value
Trend Strength
0-25
Absent or Weak Trend
25-50
Strong Trend
50-75
Very Strong Trend
75-100
Extremely Strong Trend
Figure 2: ADX Values and Trend Strength
Low ADX is a usually a sign of accumulation or distribution. When ADX is below 25 for more than 30 bars, price enters range conditions and price patterns are often easier to identify. Price then moves up and down between resistance and support to find selling and buying interest, respectively. From low ADX conditions, price will eventually break out into a trend. In Figure 3, price moves from a low ADX price channel to an uptrend with strong ADX.
Source: TDAmeritrade Strategy Desk
Figure 3: When ADX is below 25, price enters a range. When ADX rises above 25, price tends to trend.
Source: TDAmeritrade Strategy Desk
Figure 4: Periods of low ADX lead to price patterns. This chart shows a cup and handle formation that starts an uptrend when ADX rises above 25.
The direction of the ADX line is important for reading trend strength. When the ADX line is rising, trend strength is increasing and price moves in the direction of the trend. When the line is falling, trend strength is decreasing, and price enters a period of retracement or consolidation.
