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One of the difficulties in trading is that it is not easy to determine whether a trend will continue or whether it is poised to reverse. Correct risk management will ensure that an incorrect trade does not result in an excessively large loss of capital, but there is a tool that can be utilised to filter out weaker trends and help traders choose those trends showing greater strength.
Trend-following systems remain a popular way of trading, but not every breakout turns into a trend. Indeed, studies indicate that markets trend less than 30% of the time, with the rest of that being given over to range-bound trading that will frustrate those looking to take advantage of firm directional movement. The Average Directional Index (ADX) can help to reduce the number of possible trades, narrowing down a list of trade ideas to provide potentially more profitable opportunities.
What is the ADX?
The ADX, combined with the Negative and Positive Directional Indicators, are momentum indicators that can point to whether a trend is strong or weak.
The ADX itself is an indicator that ranges from zero to 100. A reading above 25 is usually cited as defining a strong trend, ie one that is likely to continue.
How is the ADX used in trading?
The ADX is based on a moving average of price range expansion, usually over a 14 day period, although this can be changed to give more or less frequent readings. It is vital to remember that the ADX is non-directional, ie it registers trend strength, not whether the price is trending up or down. For example, the chart below shows the DAX from the end of 2017 until the end of May 2018. The price falls sharply in January and February, and the rising ADX indicates that this is a strong trend.
By contrast, the price then rises from the end of March, but the ADX continues to fall, indicating that the uptrend is weakening. It can be difficult to reconcile these two ideas, but once mastered it can be seen how the ADX may be utilised in trading.
I have removed the Positive and Negative Directional lines as they are not used for providing signals and tend to cloud the issue. As with most things in trading, the simpler approach tends to be the more effective one. The second chart is the same one, but with the two lines added in, which illustrates how much they cloud the issue.
Above the green line explained
When the Positive Directional line (green) is above the Negative (red), this is another indication of possible strength, but most traders tend to use the ADX by itself and ignore the other two.