How to use ADX Indicator to Trade Stock & Binary Options

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How to Use the ADX Indicator

The ADX indicator measures the strength of a trend and can be useful to determine if a trend is strong or weak. High readings indicate a strong trend and low readings indicate a weak trend.

When this indicator is showing a low reading then a trading range is likely to develop. Avoid stocks with low readings! You want to be in stocks that have high readings.

This indicator stands for Average Directional Index. On some charting packages there are two other lines on the chart, +DI and -DI (the DI part stands for Directional Indicator). Ignore these lines. Trying to trade according to these two lines is a great way to lose money!

The only thing that we are concerned with is the ADX itself.

Note: This indicator measures strong or weak trends. This can be either a strong uptrend or a strong downtrend. It does not tell you if the trend is up or down, it just tells you how strong the current trend is!

Let’s look at a chart:

In the chart above, the ADX indicator is the thick black line (arrow). The other lines are the +DI and -DI (ignore these). The highlighted areas show how this indicator identifies trading ranges. ADX is showing a low reading and the stock is chopping around sideways.

Now look at what happens when the indicator gets into higher territory. A strong trend develops! These are the type of stocks that you want to trade.

On the right side of the indicator panel you will see a scale from 0 to 100 (only 0 through 80 are marked). Here are my guidelines for using the scale:

ADX indicator scale

If ADX is between 0 and 25 then the stock is in a trading range. It is likely just chopping around sideways. Avoid these weak, pathetic stocks!

Once ADX gets above 25 then you will begin to see the beginning of a trend. Big moves (up or down) tend to happen when ADX is right around this number.

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When the ADX indicator gets above 30 then you are staring at a stock that is in a strong trend! These are the stocks that you want to be trading!

You won’t see very many stocks with the ADX above 50. Once it gets that high, you start to see trends coming to an end and trading ranges developing again.

The only thing I use the ADX for is an additional filter in my scans, so that I can find stocks that are in strong trends. I do not even have the ADX indicator on the charts that I look at when I am looking for setups. Since the ADX is already factored into the scans, I don’t need it added to the chart itself.

I don’t pay any attention to the rising and falling of the ADX indicator. Stocks can go up for long periods of time even though the ADX may be falling (indicating that the trend is getting weak). The ideal scenario is that the ADX is rising, but I don’t find it necessary to take a trade.

I don’t use any technical indicators on my charts. I found out that technical indicators just clouded my judgement. One technical indicator may indicate a buy and one may indicate a sell. Needless to say, this can be very confusing and it just takes you attention away from the only thing that matters – PRICE.

So what is the ADX indicator good for?

This indicator is best used for screening stocks and writing scans. By adding this indicator to your scanning software, you can eliminate all of the stocks that are in trading ranges. You can then set up your scan to find only those stocks that are in strong up trends or strong down trends.

The ADX indicator does not give buy or sell signals. It does, however, give you some perspective on where the stock is in the trend. Low readings and you have a trading range or the beginning of a trend. Extremely high readings tell you that the trend will likely come to an end.

ADX: The Trend Strength Indicator

Trading in the direction of a strong trend reduces risk and increases profit potential. The average directional index (ADX) is used to determine when the price is trending strongly. In many cases, it is the ultimate trend indicator. After all, the trend may be your friend, but it sure helps to know who your friends are. In this article, we’ll examine the value of ADX as a trend strength indicator.

Introduction to ADX

ADX is used to quantify trend strength. ADX calculations are based on a moving average of price range expansion over a given period of time. The default setting is 14 bars, although other time periods can be used.   ADX can be used on any trading vehicle such as stocks, mutual funds, exchange-traded funds and futures.

ADX is plotted as a single line with values ranging from a low of zero to a high of 100. ADX is non-directional; it registers trend strength whether price is trending up or down.   The indicator is usually plotted in the same window as the two directional movement indicator (DMI) lines, from which ADX is derived (Figure 1).

For the remainder of this article, ADX will be shown separately on the charts for educational purposes.

Source: TDAmeritrade Strategy Desk

Figure 1: ADX is non-directional and quantifies trend strength by rising in both uptrends and downtrends.

When the +DMI is above the -DMI, prices are moving up, and ADX measures the strength of the uptrend. When the -DMI is above the +DMI, prices are moving down, and ADX measures the strength of the downtrend. Figure 1 is an example of an uptrend reversing to a downtrend. Notice how ADX rose during the uptrend, when +DMI was above -DMI. When price reversed, the -DMI crossed above the +DMI, and ADX rose again to measure the strength of the downtrend.

Quantifying Trend Strength

ADX values help traders identify the strongest and most profitable trends to trade. The values are also important for distinguishing between trending and non-trending conditions. Many traders will use ADX readings above 25 to suggest that the trend is strong enough for trend-trading strategies. Conversely, when ADX is below 25, many will avoid trend-trading strategies.

ADX Value Trend Strength
0-25 Absent or Weak Trend
25-50 Strong Trend
50-75 Very Strong Trend
75-100 Extremely Strong Trend

Low ADX is usually a sign of accumulation or distribution.   When ADX is below 25 for more than 30 bars, price enters range conditions, and price patterns are often easier to identify. Price then moves up and down between resistance and support to find selling and buying interest, respectively. From low ADX conditions, price will eventually break out into a trend. In Figure 2, price moves from a low ADX price channel to an uptrend with strong ADX.

Source: TDAmeritrade Strategy Desk

Figure 2: When ADX is below 25, price enters a range. When ADX rises above 25, price tends to trend.

Source: TDAmeritrade Strategy Desk

Figure 3: Periods of low ADX lead to price patterns. This chart shows a cup and handle formation that starts an uptrend when ADX rises above 25.

The direction of the ADX line is important for reading trend strength. When the ADX line is rising, trend strength is increasing, and the price moves in the direction of the trend. When the line is falling, trend strength is decreasing, and the price enters a period of retracement or consolidation.

A common misperception is that a falling ADX line means the trend is reversing. A falling ADX line only means that the trend strength is weakening, but it usually does not mean the trend is reversing, unless there has been a price climax. As long as ADX is above 25, it is best to think of a falling ADX line as simply less strong (Figure 4).

Source: TDAmeritrade Strategy Desk

Figure 4: When ADX is below 25, the trend is weak. When ADX is above 25 and rising, the trend is strong. When ADX is above 25 and falling, the trend is less strong.

Trend Momentum

The series of ADX peaks are also a visual representation of overall trend momentum. ADX clearly indicates when the trend is gaining or losing momentum. Momentum is the velocity of price. A series of higher ADX peaks means trend momentum is increasing. A series of lower ADX peaks means trend momentum is decreasing. Any ADX peak above 25 is considered strong, even if it is a lower peak. In an uptrend, price can still rise on decreasing ADX momentum because overhead supply is eaten up as the trend progresses (Figure 5).

Source: TDAmeritrade Strategy Desk

Figure 5: ADX peaks are above 25 but getting smaller. The trend is losing momentum but the uptrend remains intact.

Knowing when trend momentum is increasing gives the trader confidence to let profits run instead of exiting before the trend has ended. However, a series of lower ADX peaks is a warning to watch price and manage risk. The best trading decisions are made on objective signals, not emotion.

ADX can also show momentum divergence. When price makes a higher high and ADX makes a lower high, there is negative divergence, or non-confirmation. In general, divergence is not a signal for a reversal, but rather a warning that trend momentum is changing. It may be appropriate to tighten the stop-loss or take partial profits.

Any time the trend changes character, it is time to assess and/or manage risk. Divergence can lead to trend continuation, consolidation, correction or reversal (Figure 6).

Source: TDAmeritrade Strategy Desk

Figure 6: Price makes a higher high while ADX makes a lower high. In this case, the negative divergence led to a trend reversal.

Strategic Use of ADX

Price is the single most important signal on a chart. Read price first, and then read ADX in the context of what price is doing. When any indicator is used, it should add something that price alone cannot easily tell us. For example, the best trends rise out of periods of price range consolidation. Breakouts from a range occur when there is a disagreement between the buyers and sellers on price, which tips the balance of supply and demand. Whether it is more supply than demand, or more demand than supply, it is the difference that creates price momentum.

Breakouts are not hard to spot, but they often fail to progress or end up being a trap. However, ADX tells you when breakouts are valid by showing when ADX is strong enough for price to trend after the breakout. When ADX rises from below 25 to above 25, price is strong enough to continue in the direction of the breakout.

ADX as a Range Finder

Conversely, it is often hard to see when price moves from trend to range conditions. ADX shows when the trend has weakened and is entering a period of range consolidation. Range conditions exist when ADX drops from above 25 to below 25. In a range, the trend is sideways, and there is general price agreement between the buyers and sellers. ADX will meander sideways under 25 until the balance of supply and demand changes again.

ADX gives great strategy signals when combined with price. First, use ADX to determine whether prices are trending or non-trending, and then choose the appropriate trading strategy for the condition. In trending conditions, entries are made on pullbacks and taken in the direction of the trend. In range conditions, trend-trading strategies are not appropriate. However, trades can be made on reversals at support (long) and resistance (short).

The best profits come from trading the strongest trends and avoiding range conditions. ADX not only identifies trending conditions, it helps the trader find the strongest trends to trade. The ability to quantify trend strength is a major edge for traders. ADX also identifies range conditions, so a trader won’t get stuck trying to trend trade in sideways price action. In addition, it shows when price has broken out of a range with sufficient strength to use trend-trading strategies. ADX also alerts the trader to changes in trend momentum, so risk management can be addressed. If you want the trend to be your friend, you’d better not let ADX become a stranger.

Best ADX Strategy Built by Professional Traders

All Forex traders strive to build their own profitable strategies. Well, this day is your lucky day! We’re willing to share the best ADX strategy with you, which was built by a professional trader. Our team at Trading Strategy Guides firmly believes the easiest way to become a profitable trader is to mimic the behavior of professional traders.

However, we haven’t covered how to measure the strength of the trend in any possible time frame. You can only measure the strength of the trend by using a special trading indicator. For example, the ADX, which is an acronym for Average Directional Index.

Detecting a strong directional move is the most important skill for all traders to have. No matter what type of trader you are, after you enter a position you need a strong directional move. In order to make a profit, the move must be in the direction of your trade.

The ADX indicator trading rules can help you achieve your financial goals.

Before moving forward, we must define which technical indicator we need for the best ADX strategy. We will define the rules of ADX indicator trading. Also, read the hidden secrets of moving average, for more information.

ADX Indicators for Futures

The principles of the Average Directional Index can apply to almost all tradable assets including stocks, exchange-traded funds, mutual funds, and futures contracts. ADX has become exceptionally useful in futures markets for many reasons:

  • With a standard range of 14 bars, ADX offers a “bigger picture” than many other technical indicators.
  • ADX is time adjusted, meaning that the most recent data is given exceptional weight.
  • ADX helps you identify the strength of a trend, which will be useful for any contract being executed in the near future.
  • ADX makes it very easy to compare mutually exclusive futures contracts at once.

Futures traders enjoy using ADX as a metric because it offers the perfect blend of past and present data and future predictability. Successfully purchasing futures contracts will require you to identify which potential contracts are mispriced in the status quo. Using ordinary ADX readings for future contracts makes this possible.

Using ADX readings for major indexes (such as the DJIA, S&P 500, and others) can also help you identify whether the general market is experiencing bearish or bullish conditions.

ADX Indicator Trading Rules

Before going further into the ADX indicator trading rules, let’s define what the ADX indicator is and how you can profit from it.

The ADX indicator simply measures the strength of a trend and whether we’re in a trading or non-trading period. In other words, the ADX is a trend strength indicator. This method of technical analysis is used to identify the emergence of strong downtrends and buy signals.

We need to be very careful about how we read and interpret the ADX indicator. It is not a bullish and bearish indicator. ADX’s moving average only measures the strength of the trend.

So, if the price is going UP, and the ADX indicator is also going UP, then we have the case for a strong bullish case.

The same is true if the price is going DOWN and the ADX indicator is going UP. Then we have the case for a strong bearish case.

The first ADX indicator trading rule says, a reading below 25 signals a period of non-trading or ranging market. The second ADX indicator trading rule says, when the ADX is above 25 is enough to signal the presence of a strong bullish/bearish trend.

Going forward, keep in mind that the ADX indicator doesn’t give you any information about the direction of the market. It just provides you with information about the strength of a trend.

ADX Indicator settings

The ADX indicator uses a smoothing moving average in its calculation. We find out that the best ADX indicator settings to use is 14 periods. With our ADX indicator settings, you’ll have more accurate signals and it will help you get in a trade earlier.

The ADX indicator works best when used in combination with other technical indicators.

The best ADX strategy also incorporates the RSI indicator in order to time the market. The ADX indicator can only help us to gauge the intensity of the trend. We need to RSI indicator for entry signals.

The RSI uses a 20-period setting, which is the same as the ADX indicator settings.

Finally, your chart setup should have at the bottom both the ADX and RSI indicator. It should be the same as in the figure below.

Now, let’s see how you can effectively trade with the best ADX strategy. You will learn how to make profits by applying the ADX indicator trading rules.

The Best ADX Strategy

The ADX indicator trading rules will ensure that you only trade when there is a strong trend on the 5-minute chart or the daily chart. In this regard, the best ADX strategy is a universal strategy that performs the same, regardless of the time frame used.

Moving forward, we’re going to look for selling opportunities.

Step #1: Wait for the ADX indicator to show a reading above 25.

Before we even look to see if the market goes up or down, we must first wait for the ADX indicator to show a reading above 25. Based on the ADX indicator trading rules, a reading above 25 is signaling a strong trend and the likelihood of a trend developing.

We all know that the trend is our friend, but without real strength behind the trend, the newly trend formed can quickly fade away.

In order to gauge the direction of the trend, we also need to look at the actual price action. This brings us to the next step of the best ADX strategy.

Step #2: Use the last 50 candlesticks to determine the trend. For sell signals, look for price to develop a bearish trend.

No matter of your time frame, we need a practical way to determine the direction of the trend.

By using a sample size of 50 candlesticks to determine the trend we ensure that we trade in the moment of now. We like to keep things simple, so if the price is heading lower during the last 50 candlesticks we’re in a bearish trend.

Now, it’s time to focus on the catalyst that will trigger our sell signal for the best ADX strategy.

Step #3: Sell when the RSI indicator breaks and show a reading below 30.

For our entry signal, we’ll be using the RSI indicator that uses the same settings as the ADX indicator settings. Normally the RSI reading below 30 shows an oversold market and a reversal zone. However, smart trading means looking beyond what the textbook is saying.

In a strong trend as it’s defined by the ADX indicator that’s precisely what we want to see. We want more sellers coming into the market.

So, we want to sell when the RSI indicator breaks and shows a reading below 30.

The next important thing we need to establish is where to place your protective stop loss.

Step #4: Protective Stop Loss should be placed at the last ADX high.

In order to determine the stop-loss location for the best ADX strategy, first identify the point where the ADX made the last high prior to our entry. Secondly, find the corresponding high on the price chart from the ADX high and there you have it your SL level.

Last but not least the best ADX strategy also needs a place where we need to take profits, which brings us to the last step of this unique strategy.

Step #5: Take Profit when the ADX indicator breaks back below 25.

The best ADX strategy seeks to only capture those profits resulted from the presence of a strong trend. Once the prospects of a strong trend fade away we look to take profits and wait for another trading opportunity.

To accomplish this we take profits as soon as the ADX indicator breaks back below 25.

An ADX reading back below 25 suggests the prevailing trend is running out of strength.

Note** The above was an example of a SELL trade using the ADX indicator trading rules. Use the same rules but in reverse, for a BUY trade. In the figure below you can see an actual BUY trade example.

Conclusion – ADX Indicator

The best ADX strategy gives us very useful information because a lot of the time, we as traders don’t want to get into something that’s moving nowhere and not trending in a strong fashion. By applying the ADX indicator trading rules one can take advantage of the strength of the trend and cash in quick profits. The bottom line is that the best profits come from catching strong trends and the best ADX strategy can help you accomplish your trading goals.

You can also read about the Trader Profile Quiz.

The best ADX strategy is similar to the Best Momentum Trading Strategy for Quick Profits because both strategies seek to take advantage of the strength of the trend.

Thank you for reading!

Please leave a comment below if you have any questions about this strategy!

Also, please give this strategy a 5 star if you enjoyed it!

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