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.
Putting real dollars into a trade before you know what you're doing can be costly. Consider "paper trading" with paperMoney® and get (almost) the real deal to see how you might react in a real situation.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
While this article discusses technical analysis, other approaches, including fundamental analysis, may assert very different views.
The information contained in this article is not intended to be investment advice and is for educational purposes only. Clients must consider all relevant risk factors, including their own personal financial situation before trading.
TD Ameritrade does not make recommendations or determine the suitability of any security, strategy or course of action, for you through your use of trading tools or technical trading indicators.
Any investment decision you make in your self-directed account is solely your responsibility. Investools, Inc. and TD Ameritrade, Inc., are separate but affiliated companies and are not responsible for each other’s services or policies.
Investools does not provide financial advice and is not in the business of transacting trades. TD Ameritrade is separate from and not affiliated with Welles Wilder, and is not responsible for his services, policies, publications or other content.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.