ADX: The Trend Strength Indicator

What Is ADX?

The average directional index (ADX) is a technical indicator used by traders to determine the strength of a price trend for a financial security. Trading in the direction of a strong trend reduces risk and increases profit potential. Many traders consider the ADX to be the ultimate trend indicator because it is so reliable.

ADX quantifies trend strength. ADX calculations are based on a moving average of price range expansion over a given period of time. The default setting is 14 bars, although other time periods can be used.

ADX can be used with any financial security that trades, including stocks, mutual funds, exchange-traded funds, and futures.

What You Need to Know

• The average directional index, known as ADX, is a technical tool used by traders to identify trend strength.
• Trading with the trend is a longstanding and proven trading practice that reduces risk and increases profit potential.
• ADX calculations use a moving average of price range expansion.
• ADX isn’t useful when prices enter a trading range.
• While ADX is a lagging indicator, it is considered very reliable.

How ADX Works

ADX is plotted as a single line with values ranging from a low of zero to a high of 100. ADX is non-directional; it registers trend strength whether price is trending up or down.

The indicator is usually plotted in the same window as the two directional movement indicator (DMI) lines, from which ADX is derived (shown below).

When the +DMI is above the -DMI, prices are moving up, and ADX measures the strength of the uptrend. When the -DMI is above the +DMI, prices are moving down, and ADX measures the strength of the downtrend.

The chart above is an example of an uptrend reversing to a downtrend. Notice how ADX rose during the uptrend, when +DMI was above -DMI. When price reversed, the -DMI crossed above the +DMI, and ADX rose again to reflect the strength of the downtrend.

Quantifying Trend Strength

ADX values help traders identify the strongest and most profitable trends to trade. The values are also important for distinguishing between trending and non-trending conditions.

Many traders will use ADX readings above 25 to suggest that the trend is strong enough for trend-trading strategies, that is, trades that go with the trend. Conversely, when ADX is below 25, traders may feel that prices are in a trading range and consequently they’ll avoid trend-trading strategies.

Low ADX is usually a sign of accumulation or distribution. When ADX is below 25 for more than 30 bars, price enters range conditions, and price patterns are often easier to identify. Price then moves up and down between resistance and support to find selling and buying interest, respectively.

From low ADX conditions, price will eventually break out into a trend. For example, the chart below shows the price moves from a low ADX price channel to an uptrend with strong ADX.

The direction of the ADX line is important for reading trend strength. When the ADX line is rising, trend strength is increasing, and the price moves in the direction of the trend. When the line is falling, trend strength is decreasing, and the price enters a period of retracement or consolidation.

The ADX Line Reflects Trend Strength, Not Direction

A common misperception is that a falling ADX line means the trend is reversing. A falling ADX line means that the trend is weakening. It does not usually mean that the trend is reversing, unless there has been a price climax. As long as ADX is above 25, think of a falling ADX line as reflecting a trend that is simply less strong (shown below).

Trend Momentum

Momentum is the velocity of price changes. ADX clearly indicates when the trend is gaining or losing momentum. A series of ADX peaks is a visual representation of overall trend momentum.

Increasingly higher ADX peaks mean trend momentum is increasing. Increasingly lower ADX peaks mean trend momentum is decreasing. 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 overhead supply is eaten up as the trend progresses (shown below).

Knowing when trend momentum is increasing gives a trader the confidence to let profits run instead of exiting before the trend has ended. However, a series of lower ADX peaks is a warning to watch prices and manage risk.

ADX can also show momentum divergence. When price makes a higher high and ADX makes a lower high, there is negative divergence, or non-confirmation. In general, divergence is not a signal for a reversal, but rather a warning that trend momentum is changing. It may be appropriate to tighten the stop-loss or take partial profits.

Any time the trend changes character, it is time to assess and/or manage risk. Divergence can lead to trend continuation, consolidation, correction, or reversal (below).

Strategic Use of ADX

Price is the single most important signal on a chart. Read price first, and then read ADX in the context of what price is doing. When any indicator is used, it should add something that price alone cannot easily tell us.

For example, the best trends rise out of periods of price range consolidation. Breakouts from a range occur when there is a disagreement between the buyers and sellers on price, which tips the balance of supply and demand. Whether it is more supply than demand, or more demand than supply, it is the difference that creates price momentum.

Breakouts are not hard to spot, but they often fail to progress and end up being a trap. However, ADX tells you when breakouts are valid by showing when ADX is strong enough for prices to trend after the breakout. When ADX rises from below 25 to above 25, price is strong enough to continue in the direction of the breakout.

The best trading decisions are based on objective signals, not emotion.

ADX as a Range Finder

Conversely, it is often hard to pinpoint when price moves from trend to trading range conditions. ADX shows when the trend has weakened and is entering a period of range consolidation. Range conditions exist when ADX drops from above 25 to below 25.

In a trading range, the trend is sideways, and there is general price agreement between the buyers and sellers. ADX will meander sideways under 25 until the balance of supply and demand changes again.

ADX gives great strategy signals when combined with price. First, use ADX to determine whether prices are trending or not trending. Then choose the appropriate trading strategy for the condition.

In trending conditions, entries are made on pullbacks and taken in the direction of the trend. In range conditions, trend-trading strategies are not appropriate. However, trades can be made on reversals at levels of support (go long) and resistance (short).

How Does ADX Quantify Trend Strength

ADX is plotted according to moving average figures from a price range that’s expanding. It provides traders with specific numbers (from 0 to 100) that represent strong or weakening price trends. Traders can simply refer to the numbers to quickly assess the strength of a trend. When the ADX number rises, the trend is strengthening. When it declines, the trend is weakening. An ADX above 25 is considered to represent a strong trend. An ADX of 20 is seen as weak (and may even represent a trading range rather than a trend).

Is ADX Reliable?

It is considered by many traders to be very reliable for what it does, and is widely used. Traders can easily alter the moving average period to meet their trading needs or style.

What Are Limitations of ADX?

ADX is not a suitable indicator for trading when prices are moving sideways in a trading range. Also, it is a lagging indicator, based as it is on a moving average. Finally, it says nothing about the actual price of a security, just the direction of prices and the strength of a trend. So it’s wise to use ADX along with other technical indicators to determine specific entry and exit points.

The Bottom Line

The best profits come from trading with the strongest trends and avoiding trades in range conditions. ADX not only identifies trending conditions, it helps the trader find the strongest trends to trade. The ability to quantify trend strength is a major edge for traders.

In addition, ADX identifies trading range conditions, so a trader won’t get stuck trying to trade the trend when there isn’t one, i.e., in sideways price action. Moreover, ADX shows when price has broken out of a range with sufficient strength to use trend-trading strategies.

ADX also alerts traders to changes in trend momentum, so they can ensure that a risk management plan is in place.

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