Introduction The Average Directional Index or ADX is a trend strength indicator, so allows traders to determine whether the market is trending, ranging and how strong the trend is. The ADX is charted below the main price and comprises of The Negative Directional Index (–DI) and Positive Directional Index (+DI) lines – collectively called Directional Movement (see the below chart "ADX & Identifying a Trend"). The ADX line is sometimes plotted with these 2 lines or on it’s own. The +DI represents how strong or weak the up trend in the market is and the –DI represents how strong or weak the downtrend is. The key feature of Directional Movement & ADX is that it first identifies whether the market is trending before providing signals for trading the trend. As the ADX comprises of strength and weakness of the down and up trends it doesn’t show the direction of the trend – it just how strong or weak the overall trend is. However traders can use the ADX & Directional Movement (+DI and –DI) together to determine the trend direction. In general the bulls have the edge if (+Di) > (-DI) and vice versa. I've highlighted this on the below chart. Welles Wilder developed the ADX for commodity and currency trading, but it can be used for trading stocks. Bear in mind that commodity and currency prices are more volatile than some stocks, so the parameters may need to be changed for these non-volatile stocks to generate signals. Some stocks are volatile like tech stocks, so no parameters need to be changed to increase the sensitivity for medium term strategy forming.
Identifying a Trend and it's Strength When the ADX is above 25 and rising this indicates a trend – up or down and when the ADX is below 25 and falling it indicates a ranging market. Some traders will see a strong trend starting at +40 or +30, so be aware that these numbers aren’t set in stone. There is a degree of lag to ADX due to its smoothing techniques, so don’t be surprised if you see what you think is a trend falling under the 25 parameter – it’s only a guide.
In the above chart of McDonald's I’ve highlighted trend and range areas as per the Wilder 25 parameters. The ADX is a 14 period ADX as is the Directional Movement +DI and –DI settings. When scanning for stocks to trade, a scan where ADX > 25 will scan for all trending stocks. This will benefit all trend traders. Scan for stocks at stockcharts.com. ADX in a Trading Environment Traders like to identify trends to avoid choppy markets – It’s easier to make money in a trend. Wilder advocated that you should NOT trade a trend-based strategy if the ADX is under 25, OR if The ADX is situated below both the Directional Movement lines. Trend based traders will look for a signal that the market is starting to trend. Quite simply when the ADX lifts above 25 this is a signal that a trend may be about to start, especially if the range has been in place for some time and support/resistance is broken. The signal to trade depends on your strategy – it may be 20, 25 or 30. Instead of using the ADX as an indicator, many traders will use The ADX as a filter to look for trades to make. I.e. they will use stock filtering software to plug in the ADX to find trending markets. When the ADX is trading above both the +DI and –DI and turns downwards this signals that the trend is weakening and that the trend may be about to reverse or retrace. You’ll also see the +DI and –DI contracting towards each another. I’ve highlighted 3 points on the above chart where trend is weakening and possibly points to a retracement or reversal. On each occasion a retracement occurs. If ADX turns down when over 40 the signal is generally thought to be more robust. McDonalds Corp - Simple ADX/Oscillator Trade with Signals Although many use ADX as a trend filter it can be used for trading signals. Below we'll go through a very simple ADX trade using the McDonald's Chart above, helped by a momentum oscillator RSI for exit signals:
The +DI represents the strength of the buyers and the –DI to strength of the sellers. We can use these two lines to form trading signals. First of all the price must be trending, so ADX must be above 25. When the +DI crosses above the –DI, buyers are taking control of the market and vice versa. So, a signal is produced to buy when +DI crosses above –DI and sell/short when –DI crosses above +DI, but only when ADX>25. Other confirmations will be required at this time. But remember, traders are really only looking at the ADX to determine whether the market is trending and not necessarily looking for signals. In the chart below of AUD/NZD I’ve drawn Buy and sell signals on the +DI/-DI crossover when ADX >25. As you can see the +DI/-DI crossover has generated 8 signals, some better than others and there is one instance of whipsaw highlighted by the blue circle. AUD/NZD - ADX Crossover signals
Identifying Momentum Change and Potential Reversal Any ADX peak above 25 is considered strong, even if it is a lower peak. In an uptrend, price can still rise on decreasing ADX momentum because demand still outstrips supply albeit by decreasing margins. The below chart shows this in action. To the naked eye, price momentum still looks strong from Nov 04 to July 05, but introducing the ADX indicator shows a divergence and momentum actually decreasing decreasing from Feb to July. This leads to a price reversal for the rest of the year. To Sum Up This indicator is best used for screening stocks and writing scans. By adding this indicator to your scanning software, you can eliminate all of the stocks that are in trading ranges. You can then set up your scan to find only those stocks that are in strong up trends or strong down trends. The ADX indicator does give buy or sell signals, but it's best used to give you some perspective on where the stock is in the trend. Low readings and you have a trading range or the beginning of a trend. Extremely high readings tell you that the trend is excessive and bubble like. Traders can also utilise ADX to gauge momentum by observing divergences (as used with oscillators), leading to weakening momentum and possible retracement/reversals. Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course. |
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Introduction The Average Directional Index or ADX is a trend strength indicator, so allows traders to determine whether the market is trending, ranging and how strong the trend is. The ADX is charted below the main price and comprises of The Negative Directional Index (–DI) and Positive Directional Index (+DI) lines – collectively called Directional Movement (see the below chart "ADX & Identifying a Trend"). The ADX line is sometimes plotted with these 2 lines or on it’s own. The +DI represents how strong or weak the up trend in the market is and the –DI represents how strong or weak the downtrend is. The key feature of Directional Movement & ADX is that it first identifies whether the market is trending before providing signals for trading the trend. As the ADX comprises of strength and weakness of the down and up trends it doesn’t show the direction of the trend – it just how strong or weak the overall trend is. However traders can use the ADX & Directional Movement (+DI and –DI) together to determine the trend direction. In general the bulls have the edge if (+Di) > (-DI) and vice versa. I've highlighted this on the below chart. Welles Wilder developed the ADX for commodity and currency trading, but it can be used for trading stocks. Bear in mind that commodity and currency prices are more volatile than some stocks, so the parameters may need to be changed for these non-volatile stocks to generate signals. Some stocks are volatile like tech stocks, so no parameters need to be changed to increase the sensitivity for medium term strategy forming.
Identifying a Trend and it's Strength When the ADX is above 25 and rising this indicates a trend – up or down and when the ADX is below 25 and falling it indicates a ranging market. Some traders will see a strong trend starting at +40 or +30, so be aware that these numbers aren’t set in stone. There is a degree of lag to ADX due to its smoothing techniques, so don’t be surprised if you see what you think is a trend falling under the 25 parameter – it’s only a guide.
In the above chart of McDonald's I’ve highlighted trend and range areas as per the Wilder 25 parameters. The ADX is a 14 period ADX as is the Directional Movement +DI and –DI settings. When scanning for stocks to trade, a scan where ADX > 25 will scan for all trending stocks. This will benefit all trend traders. Scan for stocks at stockcharts.com. ADX in a Trading Environment Traders like to identify trends to avoid choppy markets – It’s easier to make money in a trend. Wilder advocated that you should NOT trade a trend-based strategy if the ADX is under 25, OR if The ADX is situated below both the Directional Movement lines. Trend based traders will look for a signal that the market is starting to trend. Quite simply when the ADX lifts above 25 this is a signal that a trend may be about to start, especially if the range has been in place for some time and support/resistance is broken. The signal to trade depends on your strategy – it may be 20, 25 or 30. Instead of using the ADX as an indicator, many traders will use The ADX as a filter to look for trades to make. I.e. they will use stock filtering software to plug in the ADX to find trending markets. When the ADX is trading above both the +DI and –DI and turns downwards this signals that the trend is weakening and that the trend may be about to reverse or retrace. You’ll also see the +DI and –DI contracting towards each another. I’ve highlighted 3 points on the above chart where trend is weakening and possibly points to a retracement or reversal. On each occasion a retracement occurs. If ADX turns down when over 40 the signal is generally thought to be more robust. McDonalds Corp - Simple ADX/Oscillator Trade with Signals Although many use ADX as a trend filter it can be used for trading signals. Below we'll go through a very simple ADX trade using the McDonald's Chart above, helped by a momentum oscillator RSI for exit signals:
The +DI represents the strength of the buyers and the –DI to strength of the sellers. We can use these two lines to form trading signals. First of all the price must be trending, so ADX must be above 25. When the +DI crosses above the –DI, buyers are taking control of the market and vice versa. So, a signal is produced to buy when +DI crosses above –DI and sell/short when –DI crosses above +DI, but only when ADX>25. Other confirmations will be required at this time. But remember, traders are really only looking at the ADX to determine whether the market is trending and not necessarily looking for signals. In the chart below of AUD/NZD I’ve drawn Buy and sell signals on the +DI/-DI crossover when ADX >25. As you can see the +DI/-DI crossover has generated 8 signals, some better than others and there is one instance of whipsaw highlighted by the blue circle. AUD/NZD - ADX Crossover signals
Identifying Momentum Change and Potential Reversal Any ADX peak above 25 is considered strong, even if it is a lower peak. In an uptrend, price can still rise on decreasing ADX momentum because demand still outstrips supply albeit by decreasing margins. The below chart shows this in action. To the naked eye, price momentum still looks strong from Nov 04 to July 05, but introducing the ADX indicator shows a divergence and momentum actually decreasing decreasing from Feb to July. This leads to a price reversal for the rest of the year. To Sum Up This indicator is best used for screening stocks and writing scans. By adding this indicator to your scanning software, you can eliminate all of the stocks that are in trading ranges. You can then set up your scan to find only those stocks that are in strong up trends or strong down trends. The ADX indicator does give buy or sell signals, but it's best used to give you some perspective on where the stock is in the trend. Low readings and you have a trading range or the beginning of a trend. Extremely high readings tell you that the trend is excessive and bubble like. Traders can also utilise ADX to gauge momentum by observing divergences (as used with oscillators), leading to weakening momentum and possible retracement/reversals. Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course. |
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