There is certainly no shortage of indicators available to traders today, yet there are only a few that are widely used and recognized. With advancements in technology we are able to observe many metrics of measurement in price action. Some popular indicators that have been used for years are the RSI or Relative Strength Index and the MACD or Moving Average Convergence/Divergence Oscillator. Another indicator to add to that list is the ADX or Average Directional Movement Index.
The ADX indicator clocked in early in 1978 and hasn’t clocked out since. This wonderful tool was created by J. Welles Wilder, the same man who created the above mentioned RSI indicator. It sits across the screen of hundreds of thousands of traders at any time. The indicator is used to gauge trend strength. Essentially the instrument is a combination of two other indicators also created by Wilder, the Positive and Negative Directional Indicators.
It doesn’t exactly correlate to candlestick action as you might think. The indicator doesn’t measure trend direction. While some indicators can be used to measure a potential breakout, this indicator is more lagging. What this means is that there must be some sort of trend active before a signal can be interpreted. On smaller time frames it could still be used to track the emergence of a larger scale trend. I’m not going to bore you with the equation, although you can review the method of calculation here. However I will show you the input settings and how you can adjust them to actually apply the ADX indicator when making your technical analysis.
I will be demonstrating the indicator on TradingView. You will need to type “ADX” in your functions search bar. There really are not too many settings to tinker with compared to other indicators. As far as the inputs go, you have three options.
Indicator Timeframe: This input basically allows you to change the viewing period independently for the ADX indicator so that it does not have to match the time frame of the candlesticks. Typically an indicator’s information will update when the time frame is changed.
ADX Smoothing: By adjusting this you can get a “more smooth” reading. This will make the line displayed by the indicator more smooth or choppy. By changing the value of this input you are changing the time period of the data being interpreted. By decreasing the value you are consolidating data over a smaller time period thus making the line more “choppy”. By increasing the value you are taking data from a larger time period which makes it more “smooth”.
DI Length: Adjusting this value is similar to adjusting the value above in terms of display response. Decreasing the value uses information from a smaller time period and increasing the value takes information from a larger time period. DI stands for Directional Indicator and is part of that complicated logarithmic equation we skipped over earlier.
Below we show an image portraying the ADX inputs. The ADX indicator is displayed three times below. The first time is with the values of 14 and 14. The other two make changes to each input to show how it will change the display of the indicator.
Now we compare the ADX with different inputs.
The Style tab has two options. The first is color/display. You can choose what color you want the line to be and in what manner you want the information displayed. I choose to use the base settings of orange and line graph. The second is the precision. Altering this input will provide additional zeros after the decimal. It shows two zeros by default and on this indicator there isn’t much to read in between so two is fine. Below is a snapshot of what that looks like.
The Visibility section is the same as all other indicators, it allows you to select which time frames you want the indicator to be displayed on.
Next we will observe the relationship between the indicator and price action. As mentioned earlier this indicator is a lagging indicator, meaning there must be some trend established first for the ADX to display the strength. The sharper the rise in price action the stronger the trend will be relayed on the graph.
Now one thing that you must note before advancing is that this indicator shows trend strength only; not trend direction. You must understand that just because the ADX is going up does not mean the candlesticks will also be going up. If a trend is going up and the ADX is also going up then it is likely the trend will continue until the ADX shows a turnaround. If the ADX is going up yet the candlesticks are going down, it means the candlesticks will likely continue to trend down until the ADX sees a turnaround. It can be used as a reversal signal and we will show how shortly. Take a look at this photo below. We will be observing the daily time frame.
You can observe in the photo above that there are some times when price action goes up while the ADX rises. There are also times in the same photo above where the price is falling yet the ADX is rising. Both of those scenarios are normal, as the ADX shows a trend’s strength, not its direction. You can generally make use of the indicator by placing your long or short with the trend direction. The photo below is the same as above, but with the ADX cycles highlighted in color codes to show the relationship (legend for colors in the same photo).
You can see in the areas of blue that while the ADX is going up the candlesticks are also going up. In the areas of white you can see where the trend weakens while the ADX reverses direction. If you enter a position based on the ADX being low and rising with candlesticks, then an ideal time to take profits would be when the ADX is declining. It’s possible that after the ADX decline you will see more growth in price action, so you may pay close attention to it for the next breakout or decide to re-enter a long based on new data.
In the areas of red the candlesticks are trending down yet the ADX is rising. Again this is normal, as the ADX indicator shows a trend strength rather than trend direction. There are two red areas in the photo above. The smaller one to the left shows a small rise in ADX and a rather small decline in price action. The second larger red area to the right shows a much steeper increase on the ADX and the candlesticks display an equally steep price decrease. This means that the downtrend was very strong at that time.
Immediately following the larger red area on the left is a white area to the right. You can see the ADX shows a prolonged decline meaning the active trend (which was a downtrend) was losing strength and likely to reverse direction.
Hopefully you can observe a relationship between the indicator and price action. Now let’s take a look at a one-hour timeframe and try to see the connection.
In the first red box we can see that the price is going down while ADX is going up. In the next white box we see the ADX declining, meaning the downtrend is losing strength. Then we can see in the next blue box that the ADX starts to rise again, now this time price action is a positive trend. In the largest white box you could have sub-framed it as there is ADX fluctuation within the area, however in candlesticks you can see the downtrend lose strength then a price consolidation before the next rise in ADX.
Now that we know how to set up the ADX indicator and how to interpret the data being shown to us, we can combine all this to find a trade opportunity. Let’s take a look at a five-minute chart below and identify some ranges.
At the time of the snapshot the trend direction was looking for a positive move as the ADX was increasing while price action was also increasing. There is currently a valid downtrend as shown by a series of lower highs and lower lows. A trader may want to short that setup. Looking at the example below we will observe how the ADX could help us make two valid trades.
In the same area of price action there are two possibilities, price increases or decreases. In this example, by trading with the active trend you can enter a short as ADX is rising and look to exit with profits as ADX starts to decline.
Using the same setup, you can also wager on a counter trend trade by taking a long as ADX declines after a valid downtrend.
In the first scenario we saw the ADX rise and entered a short because there was a valid downtrend gaining strength. In the second scenario we waited for the downtrend to show exhaustion and placed our bet that the price would increase (or at least consolidate) in our favor as a counter-trend set up.
Both setups presented a profitable opportunity. In this setup the latter trade would have been more profitable as the entry actually did catch a trend reversal. However, the first trade would have made more sense on the entry as you were trading with the valid trend by taking a short. The likelihood that price would continue to go down was high as the ADX was showing the trend to be gaining strength. The second trade was more profitable because it entered before a trend was established (which also made it more risky).
The ADX indicator has become a standard for interpreting trend strength to many, including myself. With this information being presented now you too can make use of the ADX indicator. There are many other indicators and trading tools discussed at Crypto University. You can review our available learning courses and products here.
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Written by Edward Gonzales © Crypto University 2021