Written by Timothy Sykes

The Average Directional Index (ADX) is a powerful tool in technical analysis, used to determine the strength of a trend. The importance of ADX in trading lies in its ability to help traders decide when to enter or exit a trade, based on the strength of the prevailing trend. This indicator is versatile, applicable across various markets including stocks, forex, and futures, enhancing both entry and exit strategies.

• What is the Average Directional Index (ADX)?
• How do you calculate the ADX?
• What are the components of the ADX indicator?
• How do you interpret the ADX values?
• What are the general rules for trading with the ADX indicator?
• How does the On-Balance Volume (OBV) complement the ADX?

Let’s get to the content!

## What Is the Average Directional Index (ADX)?

The Average Directional Index (ADX), created by J. Welles Wilder Jr., is designed to quantify trend strength by measuring the movement of prices in a single direction. This is achieved through the ADX line itself and two directional movement lines: the Positive Directional Indicator (+DI) and Negative Directional Indicator (-DI).

• +DI: Indicates upward trend strength.
• -DI: Shows downward trend strength.

ADX Line: Measures the overall strength of the trend, regardless of direction.

## How Do You Calculate the ADX?

Calculating the ADX involves several steps, beginning with the identification of directional movements in prices. This process helps traders assess whether a trend is gaining or losing momentum.

• Calculate the differences between consecutive highs and lows to find the True Range.
• Develop indicators for positive (+DI) and negative (-DI) directional movements based on the True Range.
• Smooth these indicators over a set period (typically 14 days) to filter out market noise.
• Combine these figures to derive the ADX.

Here’s an example of an ADX calculation:

Suppose the high price of a stock moves from \$50 to \$52, and the low shifts from \$48 to \$47. The calculations would involve determining the expansions and contractions in these price movements and applying the formula to ascertain the trend’s strength.

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Interpreting ADX values is crucial for understanding market dynamics. An ADX value above 25 typically signifies a strong trend, providing a green light for trend-following strategies.

Significance of the directional movement lines:

• A rising +DI alongside a high ADX value suggests a strong uptrend.
• Conversely, a higher -DI compared to +DI, under the same conditions, indicates a strong downtrend.

General rules for trading with the ADX focus on the values and movements of the ADX and DI lines to gauge market conditions accurately.

Key rules include:

• ADX values above 25 indicate a strong trend suitable for momentum strategies.
• The crossover of +DI and -DI can serve as signals for potential entry or exit points.

Combining ADX with other indicators like moving averages or MACD can confirm signals and refine trading strategies, mitigating risks associated with false trends.

Using the ADX in various trading strategies can significantly enhance decision-making by clarifying trend strength and potential market changes.

### 1. ADX and On-Balance Volume Strategy

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The On-Balance Volume (OBV) indicator complements ADX by measuring volume flow, which is essential for confirming the strength of trends identified by ADX readings.

Steps for this strategy:

1. Monitor OBV for increases as a confirmation of a strong trend signaled by ADX.
2. Enter trades when both ADX and OBV are in agreement on trend direction and strength.

### 2. ADX With Parabolic SAR

Parabolic SAR is designed to identify potential reversals in the market price direction, which can be strategically paired with ADX for robust entry and exit strategies.

• Enter or exit trades based on the alignment of Parabolic SAR signals with strong ADX trends.

Price divergence with ADX can indicate potential trend reversals or continuations.

• A divergence occurs when price movements do not align with ADX indications, suggesting caution.

Incorporating the Fair Value Gap could further enhance this strategy. This approach assesses the difference between a stock’s fair value and its current market price, providing additional insight into potential entry and exit points when combined with ADX trends. Understanding this relationship can lead to more informed and strategic trading moves. See Exploring the Fair Value Gap in Trading.

A 2-period ADX is used for high-frequency trading to capture quick changes in trend dynamics.

1. Set ADX periods to 2 for rapid response to price movements.
2. Engage in trades based on quick shifts indicated by this short-term ADX setup.

### 5. Holy Grail Trading Strategy

Here’s the key to the Holy Grail strategy:

• Look for minor pullbacks in a strong trend as indicated by ADX to position for potential profitable entries.

For day traders, ADX can filter out less promising trend movements, focusing only on those with significant momentum.

1. Only trade when ADX is above 25 to ensure strong trend participation.
2. Utilize +DI and -DI crossovers to determine precise entry and exit points.

## Limitations of Using the ADX Indicator

While ADX is a powerful indicator, it is not without its flaws. It may lag behind real-time events and can produce signals that might lead to misinterpretation if used in isolation.

You always want confirmation — here’s what I’d suggest:

• Combine ADX with real-time indicators like candlestick patterns or volume analysis to provide a more comprehensive view of the market conditions.
• In volatile markets, combining ADX with the Aroon Indicator can provide a sharper analysis of trend changes and durations. The Aroon Indicator is specifically designed to identify when trends are likely to start, which complements the ADX’s ability to measure trend strength. Check out our guide to the Aroon Indicator here.

If you’re wary about actually owning the underlying stock, check out our guide to CFD stocks.

## Key Takeaways

• ADX is invaluable for assessing trend strength and is effectively used in combination with directional indicators.
• Strategic use of ADX can significantly enhance trading outcomes across various markets.

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### Is ADX a Good Indicator?

ADX is highly effective for identifying strong trends, making it superior to many other trend indicators which may not quantify trend strength as clearly.

### What Is a Good Average Directional Index?

A “good” ADX value is context-dependent; generally, values above 25 indicate strong trends, while those below suggest weaker trends.

### Which Indicator Works Best with ADX?

Complementary indicators include RSI, MACD, and Stochastic Oscillator. Combining these with ADX enhances signal accuracy and helps in forming comprehensive trading strategies.

### How Does ADX Indicator Identify Key Support and Resistance Levels?

The ADX indicator is pivotal for traders looking to understand market trends’ strength. It does not directly provide support or resistance levels but helps in validating the strength of trends identified through chart patterns and trendlines. When the ADX value is above 25, it suggests a strong trend, making the support and resistance levels identified through candlesticks and chart analysis more reliable for making trading decisions.

In forex trading, the ADX indicator can significantly enhance profit-making strategies by identifying when a currency pair is entering a strong trend phase. This allows traders to position themselves in the direction of the trend with higher confidence. Combining ADX with momentum indicators and monitoring price changes can help optimize entry and exit points, potentially increasing profits.

### What Role Does ADX Play in Trading with Derivatives and ETFs?

The ADX indicator is instrumental in derivatives and ETFs trading by measuring the trend’s strength, allowing traders to make more informed decisions about when to enter or exit trades. For assets characterized by high volatility, a high ADX value may indicate a strong trend, providing a signal to execute trades that capitalize on this movement.

Combining the ADX indicator with candlestick patterns can provide powerful trade signals in forex and stock trading. When ADX indicates a strong trend (values above 25), specific candlestick formations such as ‘breakouts’ from consolidation phases can signal robust entry points. Conversely, weakening trends (ADX dropping below 25) might suggest taking caution or preparing to exit.

### What Impact Does ADX Indicator Have on Asset Pricing in Volatile Markets?

The ADX indicator helps traders gauge the strength of a trend in volatile markets, impacting asset pricing and trading strategies. By indicating the trend’s strength, ADX allows traders to adjust their strategies around assets, enhancing their ability to manage risks associated with price patterns and volatility, and securing potential profits from strong market movements.

### How Does Price Action Influence Trading Signals on Charts?

Price action, when analyzed on charts, provides crucial trading signals by depicting the trending direction and volatility of a security. These signals, coupled with the amount traded, help traders using a trading account to strategize entries and exits, optimizing their market positions based on observed patterns and trends.

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#### Timothy Sykes

Tim Sykes is a penny stock trader and teacher who became a self-made millionaire by the age of 22 by trading \$12,415 of bar mitzvah money. After becoming disenchanted with the hedge fund world, he established the Tim Sykes Trading Challenge to teach aspiring traders how to follow his trading strategies. He’s been featured in a variety of media outlets including CNN, Larry King, Steve Harvey, Forbes, Men’s Journal, and more. He’s also an active philanthropist and environmental activist, a co-founder of Karmagawa, and has donated millions of dollars to charity. Read More

* Results are not typical and will vary from person to person. Making money trading stocks takes time, dedication, and hard work. There are inherent risks involved with investing in the stock market, including the loss of your investment. Past performance in the market is not indicative of future results. Any investment is at your own risk. See Terms of Service here

The available research on day trading suggests that most active traders lose money. Fees and overtrading are major contributors to these losses.

A 2000 study called “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” evaluated 66,465 U.S. households that held stocks from 1991 to 1996. The households that traded most averaged an 11.4% annual return during a period where the overall market gained 17.9%. These lower returns were attributed to overconfidence.

A 2014 paper (revised 2019) titled “Learning Fast or Slow?” analyzed the complete transaction history of the Taiwan Stock Exchange between 1992 and 2006. It looked at the ongoing performance of day traders in this sample, and found that 97% of day traders can expect to lose money from trading, and more than 90% of all day trading volume can be traced to investors who predictably lose money. Additionally, it tied the behavior of gamblers and drivers who get more speeding tickets to overtrading, and cited studies showing that legalized gambling has an inverse effect on trading volume.

A 2019 research study (revised 2020) called “Day Trading for a Living?” observed 19,646 Brazilian futures contract traders who started day trading from 2013 to 2015, and recorded two years of their trading activity. The study authors found that 97% of traders with more than 300 days actively trading lost money, and only 1.1% earned more than the Brazilian minimum wage (\$16 USD per day). They hypothesized that the greater returns shown in previous studies did not differentiate between frequent day traders and those who traded rarely, and that more frequent trading activity decreases the chance of profitability.

These studies show the wide variance of the available data on day trading profitability. One thing that seems clear from the research is that most day traders lose money .

Millionaire Media 66 W Flagler St. Ste. 900 Miami, FL 33130 United States (888) 878-3621 This is for information purposes only as Millionaire Media LLC nor Timothy Sykes is registered as a securities broker-dealer or an investment adviser. No information herein is intended as securities brokerage, investment, tax, accounting or legal advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security or fund. Millionaire Media LLC and Timothy Sykes cannot and does not assess, verify or guarantee the adequacy, accuracy or completeness of any information, the suitability or profitability of any particular investment, or the potential value of any investment or informational source. The reader bears responsibility for his/her own investment research and decisions, should seek the advice of a qualified securities professional before making any investment, and investigate and fully understand any and all risks before investing. Millionaire Media LLC and Timothy Sykes in no way warrants the solvency, financial condition, or investment advisability of any of the securities mentioned in communications or websites. In addition, Millionaire Media LLC and Timothy Sykes accepts no liability whatsoever for any direct or consequential loss arising from any use of this information. This information is not intended to be used as the sole basis of any investment decision, nor should it be construed as advice designed to meet the investment needs of any particular investor. Past performance is not necessarily indicative of future returns.

Citations for Disclaimer

Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Available at SSRN: “Day Trading for a Living?”

Barber, Brad M. and Lee, Yi-Tsung and Liu, Yu-Jane and Odean, Terrance and Zhang, Ke, Learning Fast or Slow? (May 28, 2019). Forthcoming: Review of Asset Pricing Studies, Available at SSRN: “https://ssrn.com/abstract=2535636”

Chague, Fernando and De-Losso, Rodrigo and Giovannetti, Bruno, Day Trading for a Living? (June 11, 2020). Available at SSRN: “https://ssrn.com/abstract=3423101”