Bull or bear, the trend is your friend. Next, use the Average Directional Index to determine a trend's strength.
Bull or Bear, the trend is your friend, say traders. So when it comes to determining your opinion of a trend’s strength, the Average Directional Index can help you screen for BFFs.
A compass can be a great tool for unfamiliar territory, but it has limitations. It can tell you direction, yet it doesn’t necessarily lead you to the right trail. Sometimes you need help with the topography—a friendly trail guide who’s been there. Likewise, when trading, it may benefit you to decide the strength of a trend, not just the direction.
The Average Directional Index, or ADX, is just such an indicator. It can potentially help you determine if a trend is what you are looking for.
The ADX doesn’t bother with direction, but rather the strength of the trend. The ADX is the moving average used with the Directional Movement Index; both use a scale of 0 to 100 (See Figure 1). Actually, ADX can be used with any trending technical indicator. You can use it on weekly, daily, or intra-day charts. The typical time setting is 14 periods.
The ADX calculation can be complicated. But in a nutshell, the stronger the trend—bull or bear—the higher ADX goes. The degree of directional movement is determined by the difference between the current and previous highs and lows.
FIGURE 1: AVERAGE DIRECTIONAL INDEX (ADX) ON PAPERMONEY® As the ADX (red line) oscillates between 0-100, it tells you how strong the trend is—whether bull or bear (0 is weakest, 100 is strongest). The DI+ and DI- (yellow and blue lines) provide you with confirmation signals of the trend where they cross. For illustrative purposes only. Past performance does not guarantee future results.
When you’re using the ADX, relevant levels can be determined based on past price action, but it’s common for some traders to use 20 and 40 as key levels. Figure 2 below provides a few key points for you to remember about the direction and position of the ADX line relative to these levels.
Look at the correction that began last July on the Dow Jones Industrial Average (DJI) (Figure 1), when it lost nearly 16%. In the area highlighted, you’ll notice the DI- (blue) crossed above the DI+ (yellow), indicating according to this approach, the beginning of a bearish trend. Now fold in the ADX, you’ll notice that it is above the 20 line (red), an indication of strength in the trend. The chart offers what this study considers a trend reversal confirmation from the DI- and DI+, as well as an indication that the signal may have sufficient strength.
The next time you decide you see an indication that the trend is changing and you need to decide whether to stick to the path or take another, consider incorporating the ADX. It can confirm the strength of a signal. It beats greeting every chart signal you come across with something reminiscent of Sir Henry Morton Stanley’s famous question to his soon-to-be pal: “Dr. Livingstone, I presume?” And be not quite sure of the answer you’ll get.
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