The average directional index (ADX) measures the strength of a prevailing trend and whether movement exists in the market. The ADX is measured on a scale of 0 to 100. A low ADX value (generally less than 20) can indicate a non-trending market with low volumes, whereas a cross above 20 may indicate the start of a trend (either up or down). If the ADX is over 40 and begins to fall, it can indicate the slowdown of a current trend. This indicator can also be used to identify non-trending markets, or a deterioration of an ongoing trend. Although market direction is important in its calculation, the ADX is not a directional indicator.

Many technicians who use ADX on a regular basis use a 14-unit ADX (meaning 14 trading days) and end-of-day data (the closing prices of each security being studied). It is important to use the same parameters in each study to reveal consistent findings. Make sure that you never have more than two or three indicators in your studies, allowing for quick decisions to be made when an issue is making a strong move in either direction. (For some background reading, check out our Exploring Oscillators And Indicators Tutorial and Getting Confirmation with the Momentum Strategy.)

Finding a Strong Trend

An ADX above 30 on the scale indicates there is a strong trend in that particular time frame. Recall the principle that momentum precedes price. Therefore, when using ADX in your studies, note that when ADX forms a top and begins to turn down, you should look for a retracement that causes the price to move toward its 20-day exponential moving average (EMA). In an uptrending market, the technician will buy when the price falls to or near the 20-unit EMA, and in a downtrending market, one should look to sell when the price rises to or near its 20 unit EMA.

Investors should know that ADX does not function well as a trigger. Prices will always move faster than the ADX, as there is too much of a smoothing factor, which causes it to lag the price movement.

Interestingly, when ADX drops below 18, it often leads to a sideways or horizontal trading pattern, and the moving averages start to cluster around the price of the security. This signifies basing action within a trading range from which it is possible to draw support and resistance lines. Classic technical analysis tells us the longer the price action moves horizontal, the more likely the chart pattern will be a reversal pattern rather than a continuation pattern. When ADX moves down that low, you are in a breakout mode, and once the price breaks out, you could be setting a new trend. So draw your trendline and look for some type of breakout method.

ADX Weaknesses

Each indicator has its weaknesses and the ADX is no exception. Imagine that you have a nice long base, and jump aboard when ADX starts rising from a low level. If you successfully carry this trade all the way up to a high ADX level - somewhere above 30 - and then the market turns down, the ADX will start to decline. This decline suggests an absence of trending direction, but the price does not have an absence of direction: it is moving down.

In other words, with all the smoothing and other data that is used to determine the plotting of the ADX, we are actually looking at 30 days of data versus the 14 that we use as a default in our software models.

An Example

adx_small.gif
Figure 1: Average directional index for ORCL, June through April 2001.

As you can clearly see in this chart of Oracle Corporation, (ORCL), the downtrend from the summer of 2001 is indicated with a strong ADX trend direction and immediately turns down as the market falls off. two sell signals and a buy signal have been indicated.

The Bottom Line

The average directional index (ADX) measures the strength of a prevailing trend and whether movement exists in the market. However, this indicator does not work well as a trigger, because prices always move faster than the ADX. ADX is best used as an indicator of trend strength,

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  2. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  3. Technical Indicators

    4 Ways to Find a Penny Stock Worth Millions

    Thinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
  4. Trading Strategies

    Who Actually Trades or Invests In Penny Stocks?

    Although penny stocks are highly speculative, millions of people trade them daily. Here are 10 different types who do.
  5. Chart Advisor

    4 Stocks Still Flashing Buy Signals

    In the midst of volatility and a big market sell-off last week, these stocks are flashing buy signals.
  6. Technical Indicators

    Understanding Trend Analysis

    Trend analysis is the use of past performance to predict future price movement of a security.
  7. Forex Education

    These Are The Best Hours To Trade the British Pound

    The best times to trade the British pound are centered around economic releases at 1:30 am, 2:00 am, 8:30 am and 10:00 am U.S. ET.
  8. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  9. Chart Advisor

    Value Stocks Offer Stability in a Volatile Market

    With volatility on the rise, investors are turning to segments of strength such as value stocks. We'll take a look at several ETFs that could be worth a closer look.
  10. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
RELATED TERMS
  1. Tactical Trading

    A style of investing for the relatively short term based on anticipated ...
  2. Fintech

    Fintech is a portmanteau of financial technology that describes ...
  3. Indicator

    Indicators are statistics used to measure current conditions ...
  4. Intraday Momentum Index (IMI)

    A technical indicator that combines aspects of candlestick analysis ...
  5. Mass Index

    A form of technical analysis that looks at the range between ...
  6. Money Flow Index - MFI

    A momentum indicator that uses a stock’s price and volume to ...
RELATED FAQS
  1. What are the main signals traders use when following the Average Directional Index ...

    The average directional index, or ADX, is one of several indicators created by technical analyst J. Welles Wilder Jr. Specifically, ... Read Full Answer >>
  2. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  3. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  4. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  5. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  6. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!