Introduction
Trend chasing is an important trait for trading in the stock market. It helps one better analyze the market movements and devise a trading strategy to capitalize on gains. Knowledge of trend-chasing strategies can reduce the risk of the trader and increase their potential profits. Several different trading indicators are used by traders to access the market momentum. One such indicator is the average directional index.
In this blog, we will study the ADX indicator and understand how to use the ADX indicator to measure a trend strength. Let us first understand what the average directional index is.
What is the ADX indicator?
ADX indicator was first developed by an American engineer Welles Wilder to determine the price movements in the commodity industry, but due to its high relevancy, today this is an important indicator for technical trading of stocks and for analyzing stock trends. ADX is primarily used to study the strength of the trend. Let us now understand how ADX works.
How average directional index works:
ADX is an important trend indicator that is used to assess the strength of a stock market trend. ADX is derived from two indicators, the positive directional index (DI+) and the negative directional index (DI-). Therefore an ADX indicator will always have 3 lines:
- The positive directional indicator (DI+) line
- The negative directional indicator (DI-) line
- The ADX line.
The value of ADX lies in a range of 0-100 and is used to signify the strength of a trend irrespective of its direction. The strength of the trend generally refers to the level of influence that the buyers and sellers have over the market over a specific period of time.
The readings that are closer to zero or greater than 60 are generally a rare occurrence.
Another important aspect of the ADX indicator is the DM which stands for Directional Movement.
Let us now understand what these lines tell us
What do ADX lines tell you?
Let us now learn about some ADX indicator strategies that help the analysts study the ADX charts.
If the DI+ line is above the DI- line, it indicated the upward price trend with the ADX line measuring the strength of the uptrend. Similarly, if the DI+ line is below the DI- line it shows a downtrend in the prices. Here the ADX line is used to measure the strength of the downtrend.
A strong trend is reflected, if the ADX line is above 25. However, if the ADX line is above 40, it shows a very strong trend. Similarly, if the ADX line is below 20, it means that no trend can be shown.
If the ADX line drops after reaching a high value, it indicated the end of a trend. If the ADX line starts going up it shows a strengthening trend.
How to Calculate ADX
To calculate ADX, you first need to find +DM, -DM, and the true range (TR). Typically TR is calculated for fourteen periods.
+DM is calculated by reducing the value of the previous high from the current high.
-DM is calculated by reducing the value of the current low from the previous low.
Then the True range(TR) is calculated by reducing the low price (of the day) from the High price.
For example, Assume that for the stock of XYZ, there were the following figures on 1 March
Day low = Rs. 160
Day high = Rs. 200
Previous low = Rs. 166
Previous high = Rs. 180
Day high – previous high = Rs. 200 – Rs. 180 = Rs. 20
Previous low – current low = Rs. 166 – Rs. 160 = Rs. 6
Since Rs. 20 > Rs. 6, DM is positive in the above case and vice versa.
Now, to calculate the ADX, continue to calculate DX values for at least 14 periods.
After calculating DM, one can derive the value of DI
Then the DX is calculated as = DI 14 difference/ DI 14 sum x 100
ADX = Simple average of DX (taken for 14 periods)
ADX is undoubtedly an important tool to study stock trends but it comes with its own set of limitations. Let us now discuss some of the limitations of ADX:
Limitations of ADX
- ADX is not always considered a good indicator for the less volatile stocks, and for the more volatile stocks, it may generate some false signals.
- Since ADX is based on moving averages, it reacts slowly to any changes in the price. Hence, It is a laid-back indicator.
- ADX is not a wholesome tool for analyzing stock trends and it must be used in conjunction with other indicators when trading.
Conclusion:
When investing in the market, the trend is your only friend. It is extremely important to analyze the trend and devise a suitable strategy. ADX is one of the most used technical indicators because it is simple to use and when combined with other indicators it can help one analyze the market trends with accuracy.
ADX indicator can help one identify the strength of trends and make profits out of them. It allows one to detect favourable trading conditions and invest in profitable trends. ADX also helps one find the changes in trend momentum and allows them to manage their risks. One can get the highest returns by trading in the strongest trends. It also helps one identify the exit points from the markets and provides them with analytical insights.
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