- Average directional index (ADX) is a short-term technical indicator that can help you evaluate the market or an investment’s strength.
- ADX suggests the short-term momentum behind stocks may be weak.
- Be careful using indicators like ADX if coronavirus-induced volatility returns.
It’s been more than a year since US stocks—as measured by the S&P 500—recaptured all of their losses from the onset of the COVID-19 outbreak until the low point in March 2020. Corporate earnings continue to broadly surprise to the upside (the Q2 year-over-year earnings per share increase now stands at 86%, boosting 2021 expectations to a 40% sequential increase), central banks are still supporting economic activity, and expectations for a potentially significant US infrastructure package have helped push the S&P 500 above 4,400 for the first time ever (see US stocks push to record highs chart).
Even though stocks are now trading at new record highs, the Delta variant has renewed worries for potential disruptions to business around the world. If you are an active investor, you may have found yourself asking how strong the momentum is behind the US market. One technical indicator that can help shed some light on this question is ADX. According to ADX, the market's momentum may lack underlying strength to persist over the short term.
Why strength matters
Whereas technical indicators like RSI, MACD, and stochastics can help you determine at what price to buy and sell a stock, ADX is used to help determine how strong a trend is. From an investing perspective, strength can be an important factor as it can help determine if there is momentum behind a market move.
To understand why, consider a hypothetical stock that is rising in price. Would you rather own this stock if the uptrend were strengthening or weakening? From a technical analysis perspective, a rising stock in a strong uptrend may suggest greater likelihood of continuing to rise than the same stock whose uptrend is showing signs of weakness.
ADX up close
ADX is a short-term indicator that can be used under any type of market conditions (e.g., bull or bear markets, high or low volatility, etc.). It is simply the mean, or average, of the values of directional movement (DM) lines over a specified period. DM lines are calculated using current high and low prices. Much like RSI and stochastics, ADX fluctuates between 0 and 100. The bottom part of the chart above demonstrates what the ADX indicator looks like.
Unlike other technical indicators, however, readings above 60 do not occur frequently for ADX. In practice, most chart analysts believe a reading above 25 typically indicates a strong trend and a reading below 20 usually suggests there is no trend—with no clear signal interpretation existing between 20 and 25.
A rising ADX line generally means that an existing trend is strengthening. If ADX suggests the trend is strong (i.e., ADX is rising), then trend-following systems—such as moving averages and channel breakouts—are expected to have more validity. Alternatively, if you see a falling ADX line, which indicates an existing trend is weak or there is no trend, you may not want to place as much value in the signals given by trend-following systems.
There are actually 3 lines in the ADX indicator. The most important one is the ADX line. In addition, there are 2 other lines: A DMI plus line (sometimes shown on charts as DMI+ or DI+) and a DMI minus line (sometimes shown on charts as DMI- or DI-). DMI stands for directional movement indicator. Whereas the ADX line determines the strength of the trend, the 2 DMI lines complement the ADX line by helping determine the trend’s direction.
The direction of the trend is interpreted as positive when the DMI plus line is higher than the DMI minus line. Conversely, the direction of the trend is interpreted as negative when the DMI minus line is higher than the DMI plus line.
How strong are stocks now?
Looking at the chart of the S&P 500, stocks remain in a longer-term uptrend (the top part of the chart above). Indeed, the S&P 500 has doubled since March 23, 2020. The pace of the uptrend has slowed in recent weeks, amid worries over the Delta variant and other factors.
The direction of the uptrend is confirmed by the DMI lines (as seen in the bottom part of the chart above): The DMI plus line (~27) is above the DMI minus line (~21). However, the ADX line is sloping down and has fallen below 15, suggesting the uptrend is weak. In order for ADX to confirm the strength of the uptrend over the short term, ADX would need to climb above 25.
Adding ADX to your toolkit
There are many ways that you can incorporate indicators and technical analysis into your investing strategy. One way is to use indicators and other chart techniques to supplement your overall assessment of the fundamentals of the global economy, the business cycle, and other factors relevant to your analysis.
Of course, ADX's current reading does not necessarily mean that stocks will fall over the short term. More importantly, the lingering threat of COVID-19 could render chart patterns and indicators like ADX irrelevant. But ADX can be used to supplement your view of short-term trends.
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