The average directional index, or ADX is an indicator which measures the market in terms of its ability or inability to trend. The market will either remain in a tight trading range or it will make a directional trend, having some momentum. The ADX index is an indicator which primarily measures strength of trend, and not direction of trend. The indicator is available on charting software either as a a simple ADX indicator (measuring only strength of trend, or a more advanced version which has the same ADX oscillator plus two directional lines, all in one), but the trader reads and interprets these oscillator lines separately as they have different meanings.
The ADX indicator is useful in assessing a market and determining the probability of a new trend developing, after all markets trade almost sideways, in very tight range, for a large number of trading days during the year. And this is where many trading systems suffer because they are all directional, in their effort to detect price movements in the market, but the market only trends for a portion of the time, while for the rest of the time it remains practically trendless.
Most traders use the ADX indicator with its default settings, and believe that a market will not make a directional move if its ADX indicator reads below the level of 20. If the ADX line goes above 20 then there is a good chance that momentum is gathering pace and the market will make some directional move. The ADX index is lagging the market, so if it hints that momentum will gather pace, it simply means that the move the market is about to make in some direction, has actually already started, and this move will last for a while, and it may also turn into a much bigger price movement.
The directional lines of the ADX indicator on the other hand, when they are available on the charting software, provide clues about price direction and the direction and start or end of a trend. More specifically, the ADX trend strength line is depicted in black (it is direction neutral, it only shows trend momentum, for trends of either direction), and the directional lines are depicted in green and red. When the green directional line is above the red directional line, the market is in an up trend, or in a potential up trend. And when the reverse is true, the market is in a down trend, or at least has greater potential to develop a down trend rather than an up trend.
The above chart shows the SP500 stock index (above) and its ADX oscillator indicator including directional lines (below). The trend strength indicator is the black line, this should be treated as one indicator, and the directional lines (green and red) as a separate indicator. When the black line of the ADX goes below 20, momentum is lost in the market and traders expect a weakening trend or even total absence of trend, which means range trading will follow. When the black line goes above 20, a potential trend may be in the making. The directional green and red lines simply show what the prevailing trend is, in term of direction.
On the above chart one can see how the ADX black line rises and exceeds the level of 20, as the market gathers pace, regardless of whether the market it is going up or down, notice the two sets of blue arrows. On the first set of blue arrows the market rallies and the ADX black line rises, whereas on the second set the market drops but the ADX black line rises here as well, this is pure momentum, or strength of trend detection. The orange marks show a period of readings below 20, where the market remains almost trendless. And the red arrows show a point where the market had previously been going down, the ADX black line reversed and started to decline, hinting lack of downward momentum and an imminent reversal to the upside, further confirmed by the crossover in the directional lines as the green line crossed over the red one. Though the crossovers of the directional lines tend to come later than the reversals in the slope of the black line. In this case the market reversed to the up side for days, the directional lines clearly show an up trend, but the black ADX line still continues lower, but with a slope which is slowing down. The ADX black line continued to decline as the market made that high, but this has more to do with the fact that the previous decline stopped, not that the new high has to reverse. In such cases traders should focus on the directional lines to avoid at least some confusion, pay attention to the slope of the ADX line and where it has come from, relative to the market. As the market on the chart can actually continue straight higher, despite the ADX dropping below 20, this is all still referring to the previous decline, the market can continue straight higher and the ADX can slowly start rising above 20, or remain flat for a while.
The ADX indicator, when used properly, can help traders prepare for potential false signals and breakouts, and avoid them. It is also used by traders who switch between directionless and directional trading strategies, as these these are completely different trading strategies. When used together with other volatility and range detection indicators, the ADX indicator can work very well. The ability to detect strength of trend in the market is very important in all kinds of trading, even more so in the case of Options trading where time is against Option buyers, and on the other side of the market Option sellers, who ideally want a non trending market. All these traders need to know about volatility, strength of trend and how to detect and avoid false movements.
