Average Directional Index(ADX) is a trend indicator, which tell us when the market is trending and when moving sideways. Moreover, ADX also provide us with buy/sell signal and overbought/oversold signal.
The formula to calculate ADX is wordy so we won’t mention it here.
ADX quantify the trend strength, which helps trader identify when the market is trending strongly.
0-25 : Sideways
40-75: Strong trend
75-100: Extremely strong trend
If ADX hovers below 25 for about more than 30 bars, a consolidation pattern might be easily spotted and taken as an opportunity to ride the breakout trend. We will discuss pattern in the next chapters. For now, just remember if ADX 25 we have a trending market.
Example below is a glimpse of ADX in a strong bullish trending market:
One of very famous strategy using ADX is to spot consolidate pattern to ride the trend:
The wedge pattern above needs 5 months to complete. With ADX hovers very low for most of the formation of the pattern, it is used to help spot these kinds of pattern. The break below of the wedge provides a perfect opportunity to sell and ride the bearish trend.
2) Buy/sell signal
When plotting the indicator, there are usually 2 more lines beside ADX, which is DI+ and DI-. You are strongly recommended to use blue color for DI+ and red for DI-.
When DI+ crosses DI- from the below, we have a buy signal. When DI- cross DI+ from the below, we have a sell signal. There are times when DI+ and DI- come really close but they don’t cross and then diverge from each other again. This is a signal of trend continuing in the market.
3) Signal correction/reversal
In a strong bull market, when ADX goes up and crosses DI+ above 40, it signals that an correction is imminent. Although it might be a small correction of 6-7 bars, ADX still give us an warning of overbought market.
In this example, Price make higher high when ADX fails to hence we a divergent situation. Price corrects a few days later, which confirms the temporary weakness in internal strength.