3 Simple Ways To Identify Trending Markets – Part 2 ADX
This is part 2 of the series, for part 1 go here. In the previous article we looked at how to use support and resistance levels to identify ranges and trending phases. In this part we'll take a look at an indicator to help us solve this problem.
Method Number 2 – Average Directional Index
The Average Directional Index, or ADX as its popularly called, is one of the most common indicators use to indicate a trend and its strength. The ADX is usually comprised of 3 lines, the main ADX line and 2 other lines called +DI and -DI. On the chart below the ADX is the big black line, the +DI is the green thin line and the -DI is the red line.
The ADX is a directionless indicator, it doesn't give buy or sell signals, but one could use the +DI and -DI lines as buy or sell signals. A buy signal is generated when the +DI line goes over the -DI line, reverse for a sell signal. Usually a strong reading of the ADX is required to confirm a trend. The exact number can differ from system to system and it will greatly depend on the trading instrument and the timeframe you're trading.
Usually an ADX reading or at least 20 is required to signal a trend and readings over 30 or even 40 signify strong trend. The chart below shows the 12 day trendless period in August we used to test the S&R method in our previous article. The shaded periods indicate the periods when the ADX value held above the 40 line. There were 7 instances in this 12 day trading period when the Average Directional Index printed a value over 40. Most of the times it quickly pulled back below 40.
But on August 21, on the day we finally got a breakout of price above the 1.2442 level, not only did the ADX stay above 40 for an extended period of time, it also signaled an entry few hours before the breakeout entry above 1.2442. The ADX gave a signal full 7 hours before price broke through the level, the EUR/USD closed that hourly bar at 1.2357. So in this instance, if you used the ADX instead of price you would've been in a trade lot sooner and at a large discount of 85 pips compares to the S&R method.
Advantages and Disadvantages of the Average Directional Index
We already mentioned the main advantage of the ADX, the fact that it can get us in a trade sooner then if we simply wait for a support or resistance level to be broken. Of course this will greatly depend on what ADX value we use as a trigger, the bigger the value we use, the later an entry will be triggered.
The main disadvantage of the ADX is also the fact that it will usually get us in a trade sooner then if we wait for a S&R signal. In the chart above, before price finally broke out above the resistance on August 21, the ADX generated several signals, most of whom were probably losses. Like it always is with trading, there is a trade-off between getting in early and the number of losses and whipsaws you have to endure before the eventual win.