How to use ADX to spot a trend

Earlier this week, I was emailing a Bulletin reader about spotting trends.

How to do it?

There’s no shortage of tools available to us … and (surprise, surprise) not one of them is infallible. And by their nature, they will lag behind the trend that they’ve spotted.

Moving averages are the old favourite, and regular readers will know that I’m very loyal to my moving averages, for all their foibles.

However, I was inspired to have a rummage through my cupboard of indicators, and there, lurking at the back, rather dusty from lack of use, was the ADX: average directional index.

An indicator who’s only purpose in life is to tell us how strong a trend is.

Surely this has to be the best tool for the job …

Sizing up a trend

Click “ADX” on most trading platforms, and you’ll be rewarded with three new lines below your price chart. Something like this …

I don’t know about you – but I’m already feeling that the three lines is overkill. Here’s what they’re telling us …

The PLUS DI number tells us how strong or weak the uptrend in the market is.

The NEGATIVE DI number tells us how strong or weak the downtrend in the market is.

And the ADX number combines the two to tell us if the trend in either direction is strong or weak (it gives no information about whether it’s an uptrend or a downtrend).

Generally speaking, if the ADX level is above 40, it’s considered a strong trend. If the reading is below 20, it’s considered a ranging market. Whether or not the ADX is rising or falling is also relevant, and can tell us that a trend is beginning or ending.

Another way to evaluate the ADX is to look at its position in relation to the +DI and –DI lines.

So, if the ADX is above the +DI and –DI lines, then we have our trend. But when the ADX line dips below the +DI and –DI lines, we’re ranging.

And the third way to use them is by watching the +DI and –DI lines …

When the +DI line crosses above the –DI line, we should be looking for BUY signals.

And when the –DI line crosses above the +DI line, we should be looking for SELL signals.

So far so good?

Now we know when the market is trending – and we’ll use our trending strategies.

And when the market is range-bound, so we can apply our range-bound strategies.

Right?

If only.

Indicator weaknesses

I won’t go into the exact calculation behind the ADX indicator here, but in rough terms, is “smooths” out a lot of data – i.e. it filters out all the bumps, to give us a very general picture of what the market is doing.

All this “smoothing” is very helpful – but it comes at a price.

The first price is speed. The ADX is slow. Too often it tells you what has already happened, rather than what is happening now.

I don’t want to get churlish about this. It’s a lagging indicator, so accusing it of “lagging” is a bit like complaining to my seven-year-old that he’s being “childish” (damn – I really need to stop doing that)!

The second price, is reliability. There are times when the ADX becomes very unreliable. Fortunately for us, if we know more about our indicators, we can recognize these weaknesses, and we’ll know when we should listen to them, and when we should be skeptical about their messages.

When an ADX really comes into it’s own is after what’s called a “basing pattern” – this is a prolonged sideways period. So, if the ADX has been stuck at a low level (below 15) and moves above this level, we should listen to it.

However, problems come in when we have a choppy sideways market. With lots of “v” shaped ups and downs, the window of data that the ADX measures will sometimes contain more of an up (raising the reading), sometimes contain equal ups and downs (which will cancel each other out, giving a low reading), and sometimes contain more of a down (raising the reading again). So our ADX readings are going up and down, but the moves have, in fact, already happened by the time they’re showing up on our charts.

The low-down on ADX

Many traders swear by the ADX indicator, and won’t trade without it.

And many seem to have a fair degree of success with it (when used in conjunction with other signals).

For me, however, it’s an example of over-engineering.

I’d rather stick to a more basic indicator, like moving averages, which are more intuitive to my way of thinking.

But I’m ready to be proved wrong on this … if you’ve a technique of using ADX that’s working for you, tell us about it by clicking on the link below and posting a comment.

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