The Average Directional index Finding out if the market is trading or Trending
the ADX is an oscillator that fluctuates between 0 and 100. even though the scale is from 0 to 100, reading above 60 are relatively rare.
Low reading, namely reading below 20, indicate a weak trend- in other words, a sideways trading market, while high readings above 40 indicate a strong trend.
ADX does not grade the trend as bullish or bearish, that is it does not tell us whether the trend is up or down but merely assesses the strength, or degree, of the current trend. the ADX is used to determine whether or not a market is trending regardless of whether it’s up or down. thus a reading above 40 can equally indicate a strong down trend as well as a strong up trend.
ADX can also be used to identify potential changes in the market from a trending to a non-trending phase. when ADX begins to strengthen from below 20 and moves above 20, it is a sign that the trading phase of the market is ending and a trend is developing.
what ADX indicates
- A low ADX value, generally less than 20, indicates a non-trending market with low volumes.
- ADX value crossing above 20 may indicate the start of a trend it could either be a down trend or an up trend; as noted earlier, the ADX does not tell us which.
- when the value of ADX begins to weaken from above 40 and then drops below 40, it is a sign that the current trend is losing strength and that a trading range could develop.
directional movement is defined as the difference between the high and the low of a particular bar on a chart that falls outside the range of a previous bar.
in terms of a daily chart, price action above the previous day’s high is termed as positive directional movement (+DM), while anything below the previous day’s low is negative directional movement(-DM). this analysis can equally be applied to monthly, weekly, daily or intraday charts.
in figure +dm and -dm, the range of days 1 is line AB while line ED represents the price range of Day 2. Line CE represents the directional movement (DM).
the difference between point E and Point A in this figure is called positive directional movement (+DM) because this price action is above the previous day’s range.
correspondingly , Negative directional movement (-DM) is the distance between the current day’s low and the previous day’s low (CE in Figure -DM).
Directional Indicator (DI)
Price Movement is best measured in proportions rather than as absolute change. DM which measure the absolute directional movement alone is not sufficient to measure the true price range. for example,
If bharti Airtel Makes a moves of Rs. 10 in a day from its previous day’s close of Rs. 600, it is a 1.6% move. on the other hand, if BHEL makes a move of Rs. 4 from a close of Rs. 40, it is 10% move. thus, though the price of BHEL changes by only Rs.4, it is actually a change of 10% while airtel higher desolate price change of Rs. 10 is a change of only 1.6%.
wilder overcame this problem by comparing the positive and negative DMs with the true range. for this, he devised the directional indicator (DI) by dividing DM by the true range. we will now discuss how DI can be used to gauge the trend.
Positive and Negative Directional indicators identifying the Trend
ADX help us in determining the strength of a trend. it’s like determining how strong or weak a batsman or bowler is. recall again, however, that ADX doesn’t tell us whether the trend of the market is downward or upward.
the ADX, in turn, is derived from two other indicators, also developed by Wilder, called the positive directional indicator (+DI) and the negative directional indicator (-DI), which are described above.
the directional indicator is a momentum indicator that attempts to quantify the trending, or directional, behavior of a market.it is one of the best trend following indicators in technical analysis. it helps both identify trends, and determine whether or not price is moving quickly enough to be worth a long or short play. it also helps traders book profits while the trend is in place.
in its most basic form, buy and sell decesions can be taken by +DI and -DI crossovers:
- One can go long when +DI moves above the -DI line
- Sell short when the -DI line moves above the +DI line.
but it’s important to remember that when a stock is in a sideways trading range, this system may produce many whipsaws. using DI line crossovers at such times will result in losses as both up and down moves are short-lived.
the ADX combines +DI with -DI, and then smoothens the data with a moving average to provide a measure of the trend’s strength. because it uses both +DI and -DI, ADX does not offer any indication whether the direction of a trend is up or down, but simply of its strength. generally, readings above 40 indicate a strong trend and reading below 20 a weak trend. to catch a trend in its early stages, you might look for stocks with ADX Advancing above 20. conversely, and ADX decline from above 40 might signal that the current trend is weakening and a trading range is developing.
The ADX as a Divergence Indicator
The ADX is also sometimes used, as other momentum indicators are, as a divergence indicator that can signal an impending trend change or market reversal.
ADX values will rise to increasingly high levels along with price in a market that is trending strongly higher. But if ADX levels begin to decline even as price rises higher, this divergence between price movement and the ADX may signal that the market is losing momentum and therefore may be due for a turn to the downside. In such a situation, analysts will carefully monitor price movement for further indications of a possible trend change, the ADX decline having served as a sort of early warning signal.
- if ADX is between 0 and 25, then the security concerned is in a trading range. in other worlds, it’s most likely just moving about sideways, or is in a weak trend. Use oscillators to trade such stocks or markets, if you must.
- Once the ADX rises above 25, it is probably the beginning of a trend. big moves (UP or Down) trend to happen when the ADX is above 20. in such a situation, start using trend following indicators.
- when the ADX indicator reaches above 30, then you are staring at a stock that is in a strong trend. these are the securities that you should be trading.
- if you own stocks with ADX above 40, you must lighten your position because it is a signal that the trend may be coming to an end. A trading range is then likely to develop.
- when ADX starts falling below 30, it signals consolidation. you should start trading the emerging range through options.
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