When it comes to Momentum trading strategies, it is essential that you can confirm that a market is indeed trending.
There are a number of indicators which can indeed assist the trader spot these trends. A really helpful and effective tool is the Average Directional Index (ADX).
This, combined with the Minus Directional Index (-DI) and the Plus Directional Index (+DI) give the trader an idea of whether an asset is indeed trending in a particular direction as well as the strength with which it is trending.
We will go over the basics of the ADX as well as some ADX Trading Strategies that one can implement.
What is The ADX
The ADX is a directional index that was developed by Welles Wilder in the 1970s. The ADX is derived by using the minus directional movement and the plus directional movement.
Whereas the latter are able to give an indication of a direction of the trend, the former helps traders determine how strong that trend is.
In order to determine the directional movement of the asset, one has to take a look at the relationship between the current high / low with the previous high / low.
For example, when the current high minus the previous high is greater than the previous low minus the current low then we have a +DM. The +DM will merely be the current high minus the previous high. It will be 0 if the number is negative.
On the other hand, when the prior low minus the current low is greater than the current high minus the previous high then we have a -DM.
Once these have been gathered for a certain period of time then they are smoothed into a trend called the + / – Directional index using a smoothing variable called the Average true range.
We won’t go into the technicalities of it right now but once the trader has the + and – DI then the ADX is also plotted. When you plot the ADX on most charts, the + and – directional index will be included.
Interpretation of the ADX Indicator
The ADX is plotted as a line with the two directional indexes above and below it.
The range of the ADX is between 0 and 100 and as such is non directional. It merely gives the trader an indication of how strong the underlying trend (up or down) is.
You can also see the important relationship that there is between the Directional Index and the ADX. When the +DI is above the -DI then prices are moving up and the ADX will give an indication of that strength.
As you can see in the below image, we have GBPUSD that is plotted with daily candles. The ADX charts are beneath it with the ADX in black, the -DI in red and the +DI in green.
The ADX is measured depending on which quartile it is in. In the above charts these quartiles are into 4 zones between 30 but they are usually plotted between 100.
When it is between 75-100 there is a really strong trend. When it is between 25 and 75, it is a relatively strong trend. If it is below 25, then the trend is relatively absent.
In the chart example, it is quite clear that GBPUSD is trending downwards strongly. We can see that the red line (-DI) is above the green line (+DI) and the ADX is high and between the 25-30 range.
ADX Trading Examples
Most technical traders will make use of the ADX indicator to spot points at which they can take advantage of strong trends.
They are also helpful in identifying situations in which the trend is breaking out after it has been trading in a particular range for a certain period of time.
We will run through two of the most effective ADX trading strategies and how one can implement them with some examples.
It is important to mention that with all of these charts, we are plotting them with candlesticks in an intraday timeframe. The choice of time frame is also irrelevant as most technical studies are period independent.
Example 1: Breakout Confirmations
When the ADX is trading in a range below 25 then this means that there is no identifiable trend in the market. It usually occurs when the price of the asset is trading range bound between support and resistance levels.
As is nearly always the case, there will come a time when there is a breakout either up or down in the price outside of the current trend.
These breakouts are ideal opportunities for the trader to enter a position in the direction of the breakout and to profit from it.
However, there are many occasions when the trader is witnessing a false breakout and the price will eventually retrace back into the narrow range. The trader needs tools in order to identify that what he is witnessing is indeed a strong breakout.
This is where the ADX indicator will be able to help. Essentially, when there is a breakout from a range, the ADX indicator will jump up to indicate that a new trend is forming.
If the ADX keeps climbing on the breakout then this is an indication that the trend is indeed growing in strength. However, if the indicator starts to fall then this indicates the trend is slowing down (not necessarily reversing)
A slowdown of a trend is a possible indication that the price may retrace at some point and hence warrants an extra bit of caution from the trader.
In the below chart we have the price of NZDJPY plotted with a 4 hour candlestick chart. You can see that the price was quite range bound between the support and resistance levels.
It is also important to note that the ADX line is relatively flat and below 20 during this period. On the 21 March we can see that the price breaks through a support level.
As the price breaks this level we can see that the ADX indicator is immediately also shooting up. This is an indication that there is a strong trend behind the breakout.
The trader could have entered a short position on the pair. As the trade played out the trader would also have noticed that the ADX tended to decrease after this. This was an indication that the trend was petering out a bit.
The trader could have closed out his position and waited for the next entry point. After a limited period of sideways trade, the pair continued its downward trend and with increased velocity as evidenced by the ADX.
Example 2: ADX Divergence
When the price and an indicator such as the ADX are moving in different directions, this is termed a “divergence”. This could either be an indication that the trader should consider exiting his long position or running his profits on a short.
For example, when the price of an asset is rising and trending upwards but the ADX is slowly trending downwards, this could be an indication that momentum is losing steam. The trader should then consider exiting the trade.
On the other hand, if the price is falling and the ADX is trending up, this shows that the downtrend is increasing in strength. This means that the trader should consider letting the profits run before considering an exit.
In the below chart we have EUR/AUD that is plotted with daily candlestick chart. As you can see, the price is trending upwards.
However, when taking a look at the ADX, we can see that it is reaching lower highs and trending downwards. This is an indication that the strength of the trend is indeed decreasing.
This means that the trader should consider exiting any long positions that he was in. Indeed, as one can see the strength of the trend kept falling until the trend reversed itself and the price started falling.
When it comes to trading with technical indicators, entering positions in the direction of the trend is one of the most well practised techniques on the market.
Hence, an ADX trading strategy will help the trader spot the best trends and will also help the trader determine whether there should be caution when trading assets with a slowly weakening trend.
The ADX is also an indispensable tool to properly identify that an asset has broken out of period of sideways range trading. The trader can then trade the trend once the asset has broken through.
Of course, the ADX is best used in a toolbox with other tools and not as a standalone indicator. For example, when used with the MACD strategy the trader will better be able to spot trend reversals.