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.
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.
|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,