When intending to drastically alter their position over time, investors frequently seek to spot price patterns in stocks or other financial instruments. Charts reveal trends when prices continue to move in a single direction and can assist investors and traders with valuable entry or exit points.
However, trends might be elusive. While they are rather simple to detect visually, trading with them can be difficult. The endeavor is made very difficult by the fact that there is no way to predict when a trend will finish or when a reversal will occur until after the fact.
In order to predict a prospective shift before it occurs, technical analysts have embraced a variety of statistical indicators that assist identify the intensity and longevity of a trend. One of these indicators is the Average Directional Movement Index (ADX).
This article will focus on the ADX as a possible indicator of a trend's strength.
ADX: The Definition
Developed by Welles Wilder for commodities daily charts, the ADX is currently utilized by technical traders across several markets to determine the strength of a trend. The calculations for the ADX are based on a moving average of the growth of the price range over a specific amount of time. Although alternative time periods can be utilized, the default configuration is for 14 bars to be displayed.
In addition to the trendline, the ADX employs a positive (+DI) and negative (-DI) directional indicator.
- Positive DMI (DMI+), which is the difference between the current day's high price and the previous day's high price during the preceding 14 trading days.
- A negative DMI (DMI-), which represents the difference between the current day's low price and the prior day's low price over the preceding 14 days.
According to Wilder, the trend is strong when ADX is greater than 25; on the other hand, the trend is weak, or the price is trendless, when ADX is less than 20. Non-trending does not imply no price movement – it may not be, but the price may be altering its trend or is too volatile to provide a definite direction.
Any type of trading vehicle, including but not limited to equities, mutual funds, exchange-traded funds, and futures, can make use of ADX.
Strategies Based on the ADX Indicator
ADX data may be applied in a variety of contexts and paired with the results of other indicators to either validate or invalidate a certain investment or trading strategy.
- Analyzing Strength – The simplest straightforward application of the ADX is to determine the strength of an existing trend or to confirm a trend that may just be beginning to form. It is impossible to know for certain if a trend will take hold until after it has already begun. This indicates that a significant portion of it will have transpired by the time it is established that one exists. ADX levels can assist in providing swing traders and investors with the confidence that a trend looks to be strong enough to continue, as opposed to one that may be weak or questionable.
- Analyzing Momentum – Price movements on stocks can be prompted by releases of news or earnings, but not every single one of these price movements will necessarily develop into a noteworthy trend. ADX is able to assist in distinguishing between fleeting changes responding to news and longer-term patterns.
- Analyzing Trends – When compared to other equities, certain ones will have a greater propensity to trend in a different direction or more frequently. Comparisons of the ADX may be made across different equities to see whether ones exhibit more reliable movements in one direction or another. In addition to this, investors who might be interested in hedging their portfolios can utilize them to assist spot trends moving in either way.
The Drawbacks of Utilizing the ADX
The utilization of statistics and probability, upon which technical indicators are founded, may be of great use to traders and investors alike. Despite this, they are never going to be flawless. It is important for investors who use ADX to be aware of the following possible issues:
- Not Entirely Reliable – It is not safe to believe that technical indicators like the ADX will always provide accurate or reliable results no matter what the circumstance.
- Unbalanced Results – It is possible that ADX works better on certain stocks and trends than it does on others. The same goes for trends.
- Not so Predictive – There is a possibility that the ADX is more of a lagging indicator than a leading indicator. It is more reasonable to expect that it will confirm the existing status of a trend than to anticipate the future status.
- Lack of Insight – The very nature of trends is such that there is no set of rules that can be used to manage them. The ADX is only able to provide mathematical correlations; it cannot convey any form of subjective evaluation.
ADX – Takeaways
Indicators such as the ADX may be helpful tools for chartists and trend watchers in determining whether or not a price trend is real and how strong it is. However, crossovers can occur often, sometimes too frequently, leading to uncertainty and possible financial loss on transactions that abruptly reverse direction. False signals are more prevalent when the ADX is less than 25.
Therefore, as with any indication, the ADX should be paired with price research and maybe additional indicators to filter signals and manage risk. A trading strategy may be validated or invalidated with the use of these signals either on their own or in conjunction with the indications from other trend or oscillator indicators.