Whether bullish or bearish, the trend is your friend. Try using the average directional index (ADX) to evaluate the strength of a stock trend.
A compass can be a great tool for unfamiliar territory, but it has limitations. It can tell you direction, but it doesn’t necessarily lead you to the right trail. Sometimes you need help with the topography from a friendly trail guide who’s been there. Likewise, when trading, it can be helpful to gauge the strength of a trend, regardless of its direction.
Whether bullish or bearish, the trend is your friend as traders say. So when it comes to evaluating the strength of stock or market trends, the average directional index (ADX) can help you screen for BFFs. In a word, ADX can potentially be used as a trend strength indicator.
The ADX doesn’t bother with 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. Both trend measuring indicators use a scale of zero to 100 (see figure 1). ADX can be used with any trending technical indicator. And you can apply it to charts with multiple time horizons—weekly, daily, or intraday. (The default time setting on most charting software 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). 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 from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
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).
Look at the downward trend that began in late October (see figure 1). The rising ADX (red line) was an indication that the trend was strengthening. The ADX remained high well into early January and then started declining. This could signal that the downward trend is slowing down. The bullish crossover in the DMI, when the +DI (blue) crossed above the -DI (yellow), could be a sign that the trend may start moving back up.
Now let’s combine both indicators to observe the strength of the possible bullish trend. The ADX remained relatively flat until March, when it started moving above the 20 level, suggesting the upward trend might be strengthening. And that’s how using DMI and ADX together can potentially identify trend reversals and indicate the strength of trending stocks.
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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