The Average Directional Index (ADX) is used to gauge trend strength. Originally designed for commodity markets, the ADX is a strategy selection filter to provide insights into when a trend could be coming to an end.
This short guide is designed to cover the basics necessary to begin using the ADX in your trading in no more than 2 minutes.
Summary
- The ADX measures the strength of a trend, not its direction.
- A trend is considered strong when the ADX is above 25
- A reading below 20 indicates that the trend is weak or trend-less.
- It is best used as a filter for trend-following strategies
How To Use The ADX Indicator
Step 1: Open a chart on the BTSE platform
Step 2: Click the “Indicators” tab or push the “/” key
Step 3: Select “Average Directional Index” from the drop-down menu
Step 4: Admire your newly plotted ADX indicator
How To Trade Using The ADX Indicator
In general:
- A trend is considered as having strength when the ADX is above 25.
- A reading below 20 indicates that the trend is weakening or trend-less.
As you can see, the ADX measures the strength of the trend, not its direction. Therefore, an ADX reading above 25 can indicate the strength of both a bullish trend and a bearish trend – i.e. it depends on which way the price is going.
The ADX is best used in conjunction with other directional indicators as a filter. In particular, traders might rely on the ADX to switch between trading strategies.
As their name would suggest, many trend-following strategies perform best in a trending environment. Conversely, mean-reversion strategies generate the best results when the market is trend-less.
For example, using the ADX as a filter, a trader might use a trend-following moving average strategy when the ADX is over 25 and a mean-reverting RSI strategy when the ADX is below 20 and the trend is weak or trend-less.
Alternatively, traders might use the ADX to determine turning points in the market. To do this, we can combine the ADX with a simple moving average (SMA) to generate the following signals:
- Buy in a pre-existing bearish trend when the price crosses from below to above the 50 day SMA only when the ADX is below 20.
- Sell in a pre-existing bullish trend when the price crosses from above to below the 50 day SMA only when the ADX is below 20.
This strategy only attempts to pick a turning point when the ADX indicates that the trend growing weaker.
See below for a cherry-picked example of this strategy:
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