- Average directional index (ADX) is a short-term technical indicator that can help you evaluate an investment’s strength.
- ADX suggests stocks have the strength to continue to rally.
- Be careful using indicators like ADX if coronavirus-induced volatility returns.
As of mid-August 2020, US stocks—as measured by the S&P 500—have recaptured all of their losses since the onset of the COVID-19 outbreak. Yet the V-shaped recovery for stocks (see US stocks recover February highs chart) has not coincided with a similar recovery in the US economy. While earnings look better than expected as monetary policy has provided liquidity and investor sentiment has held up, the increasing spread of the virus in parts of the US, coupled with persistently high rates of unemployment, make for a muddled picture.
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 may have momentum to keep the rally going over the short term.
Why strength matters
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.
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.), and can complement your understanding of what’s happening in the market.
ADX 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 orange line in the bottom part of the chart below is an example of 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. No clear signal exists between 25 and 20.
A rising ADX line generally means that an existing trend is strengthening. This is noteworthy because, 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.
The chart above is a simplified version of the ADX indicator. There are actually 3 lines. The most important one, as seen above, 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?
The price section of the S&P 500 chart (top part of the first chart above) shows stocks have mostly moved in a V shape in 2020. They plummeted in March and gradually climbed over the next 4 months to re-approach their all-time highs. Recently, ADX (bottom part of the first chart above) has risen since early July to a reading of 23. The rising ADX line suggests the existing bullish trend is strong. However, the 23 reading suggests neither a strong or weak trend—it would need to climb above 25 to suggest a strong trend. Additional evidence of a strong trend is the DMI plus line being well above the DMI minus line—the latter of which has fallen below 14.
Adding ADX to your toolkit
Of course, ADX's current reading does not necessarily mean that stocks will continue to rise over the short term. The lingering threat of COVID-19 could turn the market on its head and render chart patterns and indicators like ADX irrelevant.
However, if the market remains stable, you might first use ADX to determine the strength and direction of a trend. If the trend is strengthening, then you might couple this interpretation with other trend-following indicators, such as moving averages or channels, to determine when to buy or sell, depending on your strategy. Given ADX's current signals, investors that utilize this indicator might have the confidence to think this rally has the strength to persist over the near term.
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