Understanding the Average Directional Index (ADX) to Build Trading Strategies
The ADX is a useful tool used by traders to measure the current trend of any trading vehicle such as stocks. It does not reveal whether a stock has an bearish or bullish trend. It simply quantifies the strength of the trend. The stronger the trend, the more incentive a trader has to investigate the stock in question and take on either a short or long position depending on the the scenario.
Let me illustrate the inherent characteristic of the ADX with a simple analogy from our daily lives. Suppose you open your internet browser and see that the most trending news article is about your favorite football team. You immediately know that something substantial happened in their last game. However, until you investigate further you do not know whether your team won or lost. In this scenario, think of the ADX as the platform that tells you about the most trending news items. However, it tells you nothing about the details of the news item but instead directs your attention towards it. Similarly, the ADX is used to identify strong trends in stocks and direct the attention of traders towards these stocks for further analysis as they are likely to be of more interest to them than other stocks. This is because trading in the direction of a strong trend alleviates risk and increases profit potential.
ADX calculations are based on a moving average of price range expansion over a period of time. Essentially, it depicts relative strength or weakness of a trading vehicle based on the comparison of its recent price changes and its overall price changes for a time period. In most models the time period used is 14 trading days. As seen in the figure below, the ADX is typically plotted with 2 other indices : +DMI and -DMI (Directional Movement Indices). These are directional trend indicators signaling rising and falling trends respectively of a given stock.
In the figure above it is evident that the stock price first increases steadily over a period of time, then remains relatively flat for a while after a slight drop and finally decreases steadily over a period of time. As expected, the +DMI indicator rises with increasing price trends and drops with falling price trends. The converse is true for the -DMI indicator. However, the ADX indicator has a high value during the steady rise and steady fall of the stock price. Its value started dropping during the period where the stock price remained relatively flat with neither an upward nor downward trend. In fact, ADX value was lowest deep into the period where there was neither a steady rise nor a steady fall in the stock price. It is important to note that decreasing ADX value does not mean a reversal in current trend. It indicates a reduction in strength of the current trend.
Comparing 2 ADX curves
Now that we have established how to interpret ADX, let us compare the ADX curves of two trading instruments — Apple stock (AAPL) and S&P 500 Index (SPX).
Consider the current ADX values of these two instruments. AAPL is at 70 and SPX is at 40. Clearly the price of both these instruments has been increasing steadily since January 2017 but AAPL’s ADX is significantly higher than SPX’s. Why is that? This can be attributed to 2 factors. First, even though SPX has been increasing steadily since January, there have been a few periods where the price has remained flat without much of an upward or downward trend. On the other hand, AAPL price has been incessantly increasing. Hence, ADX has fallen at times for SPX but has consistently increased for AAPL. Second, the rate of increase of AAPL price has been much higher than that of SPX. Since ADX calculations for a trading instrument are based on recent price changes relative to fluctuations in price changes over the course of previous 14 trading days, drastic movement in recent price changes will drive the ADX value up. It is interesting to note that even during a strong trend it is typically less likely that ADX of SPX reaches astronomical levels. The main reason is that it is a diversified asset and any large change in a few of its underlying stocks is usually nullified by others. Of course, this isn’t necessarily a bad thing. It’s just less risk and relatively less rewarding.
How to use ADX as a tool while building a trading strategy
The ADX is by no means a trigger that tells you whether to buy or sell an asset. It is simply an indicator of trend strength. Therefore it is not a good idea to use rising or falling ADX as indicators to buy or sell assets. Instead, the ADX can be used to make short term profits by trading in the direction of strong trends. However, you can still lose money even if you trade in the direction of a strong trend. Stock price changes can happen very rapidly and ADX has no way of triggering a buy or sell indication. It is not looking into a crystal ball and calling the shots to trade. It is merely a great way of getting the attention of traders so that they can investigate stocks that have profit generating potential. ADX is not a magical instrument that can give traders consistent profits. However, it is still a valuable indicator that traders can use to make short term profits.