What is ADX?
ADX is a trend indicator that helps an investor determine the strength of a trend. This strength can be measured for both bearish and bullish trends. If the right strategies are used, ADX can become a really good tool for an active investor. This article will help investors in understanding ADX, reading the ADX graph and guide them regarding different strategies for using ADX.
There are different types of tools to predict the price of an asset and trend indicators are one group of such tools. ADX is one of the most potent trend indicators. Trend indicators are an important tool in the arms of an investor. Their importance comes because of the fact that they decrease risks and lower returns for investors. A trend indicator, like ADX, can lead to lower risk because it allows the investors to find out if the trend is bearish or bullish. Similarly, ADX can also maximize the returns by ensuring investments are made within strong trends which, in turn, maximize returns. Therefore, a prudent investor will invest in understanding the tool of ADX.
How Does ADX Work?
An ADX value is calculated for a certain time period. Usually, that time period is 14 (days, hours, weeks etc.). An ADX value for any one period can be between zero and 100. This ADX value is the strength of an indicator. This strength does not depend on the nature (bearish or bullish) of the trend i.e. its trend neutral. A trend is considered to be strong if the value for ADX crosses a certain threshold. That threshold value is usually 25. This means that if the ADX value is above 25 then the trend is expected to be strong and vice versa. This is all the understanding that’s required for applying the tool. However, in order to better understand ADX, it is important to study its mathematical formulae. Casual readers can skip the calculation part altogether. However, I will implore them to read the origin of ADX, it contains good motivation for new or non-professional investors.
How Is ADX Calculated?
Before studying the formulae for ADX calculation, it is important to understand the utility of understanding ADX calculation. understanding the calculation for ADX will not make a major difference in an investor’s ability to use ADX. However, the understanding of this formulae will help students of investing understand the criticism and ability of the formulae. Furthermore, keen investors can mobilize this understanding to create derivatives of this measure for specific asset classes or general use. Casual readers can skip the following discussion.
A Bi-directional Moving Average Formulae:
The formulae for ADX is essentially a moving average formula. The ADX combines positive directional indicator and negative directional indicators to create a smoothed moving average. This might be too much to take in one go. Therefore, its best to look at the calculation of a single point ADX in the following steps.
Step 1: calculate up move (up move = high-for-today – high-for-yesterday)
Step 2: calculate down move (down move = low-for-yesterday – high-for-today)
Step 3: calculate positive directional indicator (+DM) and negative directional indicator (-DM)
(+DM = up move if up move > down move and up move > 0) else +DM = 0
(-DM = down move if down move > up move and down move > 0) else -DM = 0
Step 4: select the number of periods for the ADX formulae (Mr. wilder recommended using 14-periods).
The length of the periods for ADX can be anything from days to hour to minutes. It all depends on type of financial asset.
Step 5: Calculate +DI and -DI
SMMA = Smoothed Moving Average
ATR = Average True Range
Step 6: calculate ADX
Who Invented ADX? Origin Of ADX
Though understanding the history of ADX’s origin won’t do much for the investor in terms of trend detection, the story of its origin can serve as a good inspiration for those investors that come from non-finance backgrounds. ADX was invented by J. Welles Wilder in 1978. Welles was a mechanical engineer by trade who later became an investor and a property developer. So, if any of our readers are going through an imposter syndrome let Mr. Wilder be a good example of a person who used his background knowledge to into an advantage in stock investing. In a true sense, he turned his weakness into a strength.
How Do I read ADX graphs?
Interpreting ADX involves looking at the price candles as well as the ADX value. A typical ADX graph will look something like this.
The blue line marked with an arrow shows the ADX indicator. Now in the picture above, one can see many trends. However, an investor should only invest in a strong trend. In the image below, the red circles will highlight the strong trends. For these strong trends, the corresponding ADX values will show that their values are above 25. Therefore, one can see that ADX can be a good tool for detecting strong trends.
Example of ADX Strategy
After an investor learns to read an ADX graph, using it in the strategy seems to be a natural extension. There are many ADX trading strategies and the following discussion will discuss two of the most common ones.
The bi-directional strategy
The Bi-directional ADX Strategy is the most common strategy used by traders that use ADX. This strategy came from the very man who created ADX. In the bi-directional strategy, the investor looks at the ADX values as well as the positive directional and negative directional values. Before one can look at the strategy itself, it is important to explain the purpose and nature of bidirectional lines. In the image below, the reader can see the green and red bi-directional lines which have also been arrow-marked for convenience.
How Do I Interpret Bi-directional ADX lines?
Among these, the red line is the negative directional line. This line tells the relative tendency of the market to go into a bearish (down-trend) market. Meanwhile, the green line is called the positive directional line. This green line shows the tendency of the market to go into a bullish (up-trend) trend. One can say that these bi-directional forces are like two strong animals (a bull and a bear) pulling the market in both directions. Sometimes the up-trend is stronger than the downtrend. In the above diagram, the uptrend will overpower the downtrend when the green line is above the red line. When this happens, the market will enter a bullish spell. The opposite is true for a downtrend.
Is A Strong Trend Needed?
Does this mean that an investor should assume a strong bullish market whenever the green line (positive directional line) is above the red line? The short answer is No. When using ADX, one cannot forget the basics. A strong trend only exists when the ADX value is above 25. Therefore, an investor should only follow the bi-directional strategy when the ADX value is above 25. For example in the image below, strong bullish and bearish trends have been identified as shaded areas.
However, the ADX threshold of 25 is not set in stone, and could be altered to fit the market you’re working with. However, in most cases, a value of 25 will work very well!
Using ADX as a double check mechanism:
ADX is a good tool on its own. However, it becomes even better when used with other tools. Relying on one tool is a mistake seldom committed by rich investors. In that role, ADX can serve as a good complementary tool. One such example would be to combine the results of an oscillator like RSI with that of a trend detector like ADX. However, the reader needs to be reminded that all tools need to be combined with domain knowledge to be fully useful.
While using these strategies, the investor will also need to keep ADX’s shortages in mind.
Cons of ADX
ADX is a good tool. Tools are useful in the hands of a good skilled investor. Skilled investors don’t get blind-sided by the tools that they are using because they know the weakness of their tools. This applies to ADX as well.
First, ADX is a lag measure. This means that ADX will only gauge the strength of an indicator once the trend has already been established. This can be a disadvantage in two possible situations. First, if the investor’s strategy counts on investing before the turn of a trend then ADX is useless.
Second, some investors follow a ranging strategy that depends on the market remaining stable. ADX provides no such forewarning and hence these investors can be caught off-guard at the onslaught of bearish or bullish trends