Whether bullish or bearish, the trend is your friend. Try using the average directional index (ADX) and directional movement index (DMI) to evaluate the strength of a stock trend.
A mountain and a hill both have inclines and declines, but the mountain’s slopes are likely to be steeper than those of a hill. If you’re using a street map as your trail guide, it might be difficult to know how steep the slopes are. You may need to look at a detailed trail app to do more in-depth analysis of the topography. Likewise, when looking at trends in the stock market, it may be simple to identify bullish or bearish trends, but it can be helpful to gauge the strength of the trend in addition to the direction.
Whether bullish or bearish, the trend is your friend, as traders say. But how strong is that trend? When it comes to evaluating the strength of stock or market trends, the average directional index (ADX) is an indicator that could help you screen for BFFs. In other words, the ADX can potentially be used as a trend strength indicator.
The ADX doesn’t really consider trend direction but rather the strength of the trend. The ADX is often used along with the directional movement index (DMI), which is made up of the plus directional indicator (+DI) and the minus directional indicator (-DI). These two indicators, +DI and -DI, measure a trend’s direction by looking at the difference between current and previous highs and lows.
The ADX calculation can be complicated, but in a nutshell, it plots the average of the difference between +DI and -DI. The stronger the trend—bull or bear—the higher the ADX goes.
ADX and DMI indicators use a scale of zero to 100. When J. Welles Wilder developed the ADX and DMI, he applied the indicators to the commodity and currency market. However, you can use them on stocks and apply them to charts with multiple time horizons—weekly, daily, or intraday. It’s worth noting that you may find more trading signals in the more volatile stocks because their movements are similar to what you could find in the commodity and currency market.
When you’re using the ADX indicator, you might determine relevant levels based on past price action. But traders also use 20 and 40 as key levels (see table 1).
You could look at the ADX independently and, using the cheat sheet in table 1, determine whether a trend is strengthening, at an extreme level, or weakening. In the chart in figure 1, when the ADX crossed above 20, it was an indication the upward trend in the stock price might be strengthening. But it might be helpful to try to determine if the directional movement is positive or negative, and the DI crossover could provide some clues.
FIGURE 1: AVERAGE DIRECTIONAL INDEX (ADX). As the ADX (red line) oscillates between zero and 100, it tells you how strong the trend is—whether bull or bear (zero is weakest; 100 is strongest). The +DI and -DI (blue and yellow lines, respectively) offer potential confirmation signals when they cross. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
In figure 1, the +DI crossed above the -DI a little earlier than when the ADX crossed above 20. Considering that +DI was higher than -DI, this suggested that directional movement was positive. The ADX remained high for quite a while before dipping below the 20 level. Prior to the ADX dropping below 20, the -DI crossed below the +DI. This was an indication the upward trend could be slowing down.
In this example, both the DMI crossovers took place a little earlier than the trend strengthening or weakening signals from the ADX. But the +DI was above the -DI when the ADX was trending higher, and the -DI was below the +DI when the ADX was below 20. Both indicators were in agreement. But that may not always be the case. Even though DMI and ADX together can potentially identify trend reversals and indicate the strength of trending stocks, there may be times when the signals may not be valid. Given there are no guarantees when it comes to using indicators, it may be a good idea to use the ADX and DMI with other trending technical indicators such as moving averages, moving average convergence divergence, and Parabolic SAR for additional confirmation.
The next time you think a trend is changing and you need to decide whether to stick to that “friend” or find another, consider trying the ADX to confirm the trend’s strength and DMI to identify trend direction. It beats trying to scale every peak and valley on a chart.
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Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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