Trading in the direction of a strong trend reduces risk and increases profit potential.

The average directional index (ADX) is used to determine when the price is trending
strongly. In many cases, it is the ultimate trend indicator. After all, the trend may be
your friend, but it sure helps to know who your friends are. In this article, we'll examine
the value of ADX as a trend strength indicator.

Introduction to ADX
ADX is used to quantify trend strength. ADX calculations are based on a moving
average of price range expansion over a given period of time. The default setting is 14
bars, although other time periods can be used.1 ADX can be used on any trading
vehicle such as stocks, mutual funds, exchange-traded funds and futures.

ADX is plotted as a single line with values ranging from a low of zero to a high of 100.
ADX is non-directional; it registers trend strength whether price is trending up or
down.2 The indicator is usually plotted in the same window as the two directional
movement indicator (DMI) lines, from which ADX is derived (shown below).

When the +DMI is above the -DMI, prices are moving up, and ADX measures the
strength of the uptrend. When the -DMI is above the +DMI, prices are moving down,
and ADX measures the strength of the downtrend. The chart above is an example of
an uptrend reversing to a downtrend. Notice how ADX rose during the uptrend, when
+DMI was above -DMI. When price reversed, the -DMI crossed above the +DMI, and
ADX rose again to measure the strength of the downtrend.
Quantifying Trend Strength
ADX values help traders identify the strongest and most profitable trends to trade. The
values are also important for distinguishing between trending and non-trending
conditions. Many traders will use ADX readings above 25 to suggest that the trend is
strong enough for trend-trading strategies. Conversely, when ADX is below 25, many
will avoid trend-trading strategies.

ADX Value Trend Strength

0-25 Absent or Weak Trend
25-50 Strong Trend
50-75 Very Strong Trend
75-100 Extremely Strong Trend

Low ADX is usually a sign of accumulation or distribution. When ADX is below 25 for
more than 30 bars, price enters range conditions, and price patterns are often easier to
identify. Price then moves up and down between resistance and support to find selling
and buying interest, respectively. From low ADX conditions, price will eventually break
out into a trend. Below, the price moves from a low ADX price channel to an uptrend
with strong ADX.
The direction of the ADX line is important for reading trend strength. When the ADX
line is rising, trend strength is increasing, and the price moves in the direction of the
trend. When the line is falling, trend strength is decreasing, and the price enters a
period of retracement or consolidation.
A common misperception is that a falling ADX line means the trend is reversing. A
falling ADX line only means that the trend strength is weakening, but it usually does
not mean the trend is reversing, unless there has been a price climax. As long as ADX
is above 25, it is best to think of a falling ADX line as simply less strong (shown below).
Trend Momentum
The series of ADX peaks are also a visual representation of overall trend momentum.
ADX clearly indicates when the trend is gaining or losing momentum. Momentum is the
velocity of price. A series of higher ADX peaks means trend momentum is increasing.
A series of lower ADX peaks means trend momentum is decreasing. Any ADX peak
above 25 is considered strong, even if it is a lower peak. In an uptrend, price can still
rise on decreasing ADX momentum because overhead supply is eaten up as the trend
progresses (shown below).

Knowing when trend momentum is increasing gives the trader confidence to let profits
run instead of exiting before the trend has ended. However, a series of lower ADX
peaks is a warning to watch price and manage risk. The best trading decisions are
made on objective signals, not emotion.

ADX can also show momentum divergence. When price makes a higher high and ADX
makes a lower high, there is negative divergence, or non-confirmation. In general,
divergence is not a signal for a reversal, but rather a warning that trend momentum is
changing. It may be appropriate to tighten the stop-loss or take partial profits.
Any time the trend changes character, it is time to assess and/or manage risk.
Divergence can lead to trend continuation, consolidation, correction or reversal
(below).

Strategic Use of ADX

Price is the single most important signal on a chart. Read price first, and then read
ADX in the context of what price is doing. When any indicator is used, it should add
something that price alone cannot easily tell us. For example, the best trends rise out
of periods of price range consolidation. Breakouts from a range occur when there is a
disagreement between the buyers and sellers on price, which tips the balance
of supply and demand. Whether it is more supply than demand, or more demand than
supply, it is the difference that creates price momentum.

Breakouts are not hard to spot, but they often fail to progress or end up being a trap.
However, ADX tells you when breakouts are valid by showing when ADX is strong
enough for price to trend after the breakout. When ADX rises from below 25 to above
25, price is strong enough to continue in the direction of the breakout.
ADX as a Range Finder
Conversely, it is often hard to see when price moves from trend to range conditions.
ADX shows when the trend has weakened and is entering a period of range
consolidation. Range conditions exist when ADX drops from above 25 to below 25. In
a range, the trend is sideways, and there is general price agreement between the
buyers and sellers. ADX will meander sideways under 25 until the balance of supply
and demand changes again.

ADX gives great strategy signals when combined with price. First, use ADX to
determine whether prices are trending or non-trending, and then choose the
appropriate trading strategy for the condition. In trending conditions, entries are made
on pullbacks and taken in the direction of the trend. In range conditions, trend-trading
strategies are not appropriate. However, trades can be made on reversals at support
(long) and resistance (short).

The Bottom Line: Finding Friendly Trends

The best profits come from trading the strongest trends and avoiding range conditions.
ADX not only identifies trending conditions, it helps the trader find the strongest trends
to trade. The ability to quantify trend strength is a major edge for traders. ADX also
identifies range conditions, so a trader won't get stuck trying to trend trade in
sideways price action. In addition, it shows when price has broken out of a range with
sufficient strength to use trend-trading strategies. ADX also alerts the trader to
changes in trend momentum, so risk management can be addressed. If you want the
trend to be your friend, you'd better not let ADX become a stranger.

Those interested in learning more about ADX and other financial topics may want to
consider enrolling in one of the best technical analysis courses currently available.

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