This Unique Indicator Helps Traders Avoid ‘Dead Money’ Stocks
The Average Directional Index (ADX) is one of the few technical indicators that measure the strength of the trend independent of price.
To put it simply, this means that ADX tells you whether the stock, future or index being analyzed is trending. ADX does not offer any insight into the direction of the trend. A high ADX can be seen whenever prices are moving up or down.
What Is Average Directional Index (ADX)?
ADX is calculated from the Directional Movement Index (DMI).
DMI plus (+DI) and DMI minus (-DI) are two indicators that are defined in the Directional Movement Index article. All three of these tools were introduced in J. Welles Wilder’s 1978 book, New Concepts in Technical Trading Systems. Wilder applied the indicators to futures, but they are now widely applied to individual stocks, ETFs, and indexes.
The calculations are complex and the indicator is readily available at charting sites or in charting software packages. In general, finding ADX involves combining exponential moving averages (EMAs) of +DI, -DI and the daily ADX to create a smoothed indicator that rises when prices are in a strong trend. The default values for all of the inputs are 14 days, although any other time period can be used.
How Traders Use ADX
Many traders use ADX to identify the best trading candidates. Traders make money only when the price is moving, after all, and ADX points to the most volatile periods of market activity. Some traders will scan for the stocks or futures with the highest ADX while others use a static level to help spot trading opportunities.
It’s also important to note that traders often combine ADX with moving averages or indicators like stochastics.
A static value for determining trendiness was the original method described by Wilder. He noted that a strong trend is underway whenever ADX is above 25. He also defined the market as “trendless” when ADX falls below 20. (Wilder did not address what ADX means when the value is between 20 and 25.)
Take a look at the chart of the SPDR Gold Shares (NYSE: GLD) ETF below. ADX is simplified (without DMI plus or minus) in the lower bar.
We can see GLD’s run up in late 2019, but ADX fell below the crucial 20 threshold. ADX defines this as “trendless,” and indeed we can see the price chart going through a period of consolidation. Interestingly, but ADX remained above 25 through the worst of the Covid-19 selloff, even though GLD sold off mercilessly along with other assets in the market. But as soon as the chaos settled somewhat, GLD took another leg higher, validating ADX’s signal that the trend was still “in play.”
Today, we can see that ADX is below 20 again, which suggests we’re in another period of consolidation.
Why ADX Matters To Traders
Traders make money in trends. ADX highlights strong trends, but other indicators are needed to decide whether the trend is up or down.
Being long or short a security that is in a narrow trading range ties up trading capital. This keeps the trader out of other positions that could be more profitable. ADX is one of the few tools traders have to objectively identify trends. This can help limit trades in “dead money” securities that have little volatility and low potential profitability.
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