The average direction index (ADX) is used to find price trends. ADXR supplements it with price trend strength info. Use them with trend-following strategies.
- DXR (Average Directional Movement Index Rating)
- Interpretation
- ADX in Trending and Range Identification
- Conclusion
ADX evaluates absolute values, meaning that it works out how strong a trend is regardless of which way it’s heading, so whether the trend is pointing upwards or downwards, the strength value it’s given is the same.
The ADX appears at the bottom of the price chart, and it shows the price using the difference between a pair of directional movement indicator measures labeled +DMI and -DMI. The plus and the minus of each of them obviously indicates which way the trend is heading.
The ADX usually has a (14,14) setting, which means it includes 14 past price bars, that’s what the first number is saying. The second function is a smoothing setting that can raise or lower the amount of importance given to recent price information.
Lowering either number in the settings results in more standout trends (ADX number goes up) because then it’s looking at a narrower portion of the price data. The lower the setting the stronger the apparent trends will seem because every fluctuation will be given greater significance than it probably deserves. At the other extreme, higher settings will likely miss some trends altogether.
DXR (Average Directional Movement Index Rating)
ADXR works out the extent to which momentum is changing in the ADX, and it’s represented by another line. You can alter the number of period bars used to get the amount of change over time that suits you.
A 0 period effectively means that the ADX and ADXR are the same. Changing the period to 90 means that the ADXR measures the momentum change over a longer stretch (the ADX for the previous 90 price bars) which will probably mean that you won’t get much useful information from it. A setting of 10 is more usual and more helpful.
In essence, ADXR is a lagging indicator that works as an averaged ADX. With trending signals, the ADXR always produces them after the ADX.
Some traders take it as a buy signal when ADX heads above ADXR, and when it drops below then they see this as a sell signal, assuming either ADX or both of them are at either 25 or above.
Interpretation
ADX and ADXR interpretations amount to the same thing. The higher the value, the stronger the trend. Using them together and looking for conjunctions between them is a more conservative approach but one that should yield more accurate trading signals.
25 or higher on either indicator is seen by many as a good sign that price has enough momentum to make it a tradable trend. For anything less than 25, trend-following is to be avoided.
Whichever way the ADX line is going tells you the strength of the trend. When the ADX is going up, the strength of the trend is doing the same. A falling ADX signals a slowing and that price may become range-bound. This doesn’t point to a reversal, just increasing weakness.
Even if ADX is heading down, as long as it’s still at 25 or higher, it’s the sign of a strong trend.
Letting trades run when ADX is higher than 25 (or by combining a 25 or higher reading with crossings of ADX/ADXR under the more conservative system) is touted by momentum/trend traders who believe in letting “winners run”.
A trend that is slowing but is still over 25 isn’t a signal to exit, but it does point to slowing momentum.
ADX can also point to a parting of the ways between price and momentum/trend. If price is hitting at a higher high, but ADX, though strong, is on a downward slope, it could be a sign that momentum may be easing back.
In this instance, a trader might want to cash out some profit or reduce their position size or maybe move their stop-loss nearer to where the price is currently sitting. Whatever your response to this kind of change it’s a good idea to think about the risk implications and manage them appropriately.
ADX in Trending and Range Identification
Price is the most important part of technical analysis, but it’s only the beginning, and traders need to add to the total picture with appropriate technical indicators.
In markets that are range-bound, received wisdom is that when a trading range becomes tighter the chances of an imminent breakout become greater. ADX can help traders find these opportunities and tell them whether they have self-sustaining momentum, usually indicated when a breach goes over 25.
When ADX dips under this point, price could still look to be in a clear trend but it will be taken as one that is growing weaker or that range-bound behavior is likely to happen. In such markets, buyers and sellers pretty much agree on price. These markets feature narrow bid-ask spreads, and for any type of trend to take off will take some kind of impetus to alter the dynamics of supply and demand.
Conclusion
ADX and ADXR can give traders signals to inform momentum or trend-following strategies. The overarching idea behind this approach is that trending markets yield better opportunities for profit than ranging markets.
ADX tells us if price is trending or not, and ADXR then tells us if ADX is heading up or down.
ADX higher than 25 and higher than ADXR could be seen as a buy signal. When ADX is 25 and ADXR goes over ADX, you may take it as a sign to leave a long trade or start a sell trade. When ADX is between 0 and 25 you could see it as a call to stay away from trend-following strategies completely.
There are those who use ADX on its own and who take trades in the direction of the current trend on a pullback to a support or resistance level. Whichever approach you decide to take, consider using ADX and ADXR only as part of a comprehensive and risk-managed trading strategy.
