If you are an active investor, you may have found yourself asking how strong the momentum is behind the market's recent ups and downs. One technical indicator can help shed some light on this question: the average directional index (ADX). According to ADX, the market may be lacking clear conviction over the short term.
Why strength matters
There are many ways that you can incorporate 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.
To understand why, consider a hypothetical stock that is rising in price. Would you rather own this stock if the uptrend were strengthening (e.g. an increasing number of buyers amid strong volume) or weakening (e.g., a decreasing number of buyers and volume)? 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 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 current low prices (for more information on how to calculate these values, click here).
Much like RSI and stochastics, ADX fluctuates between 0 and 100. It is typically plotted below the price chart (see the orange line in the bottom part of the chart below).
Unlike those other 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.
ADX in action
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 three lines. The most important one, as seen above, is the ADX line. In addition, there are two other lines: a DMI plus line (commonly shown on charts as DI+) and a DMI minus line (commonly shown on charts as DI-). DMI stands for directional movement indicator. Whereas the ADX line determines the strength of the trend, the two 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?
As the price chart of the S&P 500 above shows, you can see that stocks (top half of chart) moved lower from early November 2015 through mid February 2016, before recovering in recent weeks. As of March 22, the DMI plus line (the dark blue line in the ADX indicator in the bottom half of the chart) is above the DMI minus line (the red line in the ADX indicator), suggesting the short-term direction of the trend is up.
The S&P 500 and the ADX line have moved in different directions for most of 2016 (i.e., ADX increased as the S&P declined, and vice versa), suggesting there was not much conviction during the early 2016 downtrend, according to this indicator. However, both the S&P 500 and ADX have been moving higher in recent weeks, suggesting some conviction in the recent rally.
Now, let's look at the strength of this uptrend, as measured by ADX. Since late January, the ADX line has been declining (although it has begun to turn higher in mid March). According to this indicator, that could suggest there was not much strength behind the downturn in stocks in the early part of the year. Consequently, chart and technical analysis users may not be able to rely on the validity of trend-following systems. This is confirmed by the level of the ADX line (~22 as of March 22, 2016), which signifies no clear trend.
The combination of all these signals could indicate that there is reason to be somewhat uncertain about the strength of market's trends this year, according to ADX. But a bullish confirmation of the recent uptrend's strength would be given if ADX continues to rise (along with the S&P 500) above 25.
A powerful resource
ADX is an 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. 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, Bollinger Bands, and others, to determine when to buy or sell, depending on your strategy.
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