Today we are going to discuss the ADX Indicator which is favorite to so many traders and yet often overlooked. If you like them — give a thumb up and share on social media!
Stocks, Forex or Both? Trading with Heikin Ashi Candles. Bollinger Bands Indicator Part 1. Wilder designed ADX with commodities and daily prices in mind, but these indicators can also be applied to stocks.
Used together, chartists can determine both the direction and strength of the trend. Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between the highs. Directional movement is positive plus when the current high minus the prior high is greater than the prior low minus the current low.
A negative value would simply be entered as zero. Directional movement is negative minus when the prior low minus the current low is greater than the current high minus the prior high. This so-called Minus Directional Movement -DM equals the prior low minus the current low, provided it is positive.
The chart above shows four calculation examples for directional movement. The third pairing shows a big difference between the lows for a strong Minus Directional Movement -DM. The final pairing shows an inside day, which amounts to no directional movement zero.
Negative values revert to zero. All inside days will have zero directional movement. The smoothed moving average is calculated over the number of periods selected, and the average true range is a smoothed average of the true ranges. Variations of this calculation typically involve using different types of moving averages, such as an exponential moving average, a weighted moving average or an adaptive moving average.
As seen in the ADX calculation, there is a lot of smoothing involved and it is important to understand the effects. ADX values using only 30 periods of historical data will not match ADX values using periods of historical data. ADX values with days or more of data will remain consistent. As with an exponential moving average, the calculation has to start somewhere so the first value is simply the sum of the first 14 periods. As shown below, smoothing starts with the second period calculation and continues throughout.
First, calculate an average for the first 14 days as a starting point. The second and subsequent calculations use the smoothing technique below:. Crosses of these directional indicators can be combined with ADX for a complete trading system. Before looking at some signals with examples, keep in mind that Wilder was a commodity and currency trader. The examples in his books are based on these instruments, not stocks. This does not mean his indicators cannot be used with stocks.
Some stocks have price characteristics similar to commodities, which tend to be more volatile with short and strong trends. Chartists will likely need to adjust the indicator settings or the signal parameters according to the characteristics of the security. This determination helps traders choose between a trend following system or a non-trend following system. Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below There appears to be a gray zone between 20 and As noted above, chartists may need to adjust the settings to increase sensitivity and signals.
ADX also has a fair amount of lag because of all the smoothing techniques. Many technical analysts use 20 as the key level for ADX. The stock moved from a strong uptrend to a strong downtrend in April-May, but ADX remained above 20 because the strong uptrend quickly changed into a strong downtrend. There were two non-trending periods as the stock formed a bottom in February and August.
A strong trend emerged after the August bottom as ADX moved above 20 and remained above Wilder put forth a simple system for trading with these directional movement indicators. The first requirement is for ADX to be trading above This ensures that prices are trending.
Many traders, however, use 20 as the key level. Wilder based the initial stop on the low of the signal day. Wait for this low to be penetrated before abandoning the signal. Once the trend develops and becomes profitable, traders will have to incorporate a stop-loss and trailing stop should the trend continue.
The high on the day of the sell signal becomes the initial stop-loss. The chart above shows Medco Health Solutions with the three directional movement indicators. Note that 20 is used instead of 25 to qualify ADX signals. A lower setting means more possible signals. The green dotted lines show the buy signals and the red dotted lines show the sell signals. Wilders initial stops were not incorporated in order to focus on the indicator signals. Some occur with ADX above 20 validate signals.
Others occur to invalidate signals. As with most such systems, there will be whipsaws, great signals and bad signals. The key, as always, is to incorporate other aspects of technical analysis. For example, the first group of whipsaws in September occurred during a consolidation. Moreover, this consolidation looked like a flag, which is a bullish consolidation that forms after an advance.
It would have been prudent to ignore bearish signals with a bullish continuation pattern taking shape. It would have been prudent to ignore a buy signal so close to this resistance zone.
These three signals were pretty good, provided profits were taken and trailing stops were used. Wilders Parabolic SAR could have been used to set a trailing stop-loss. Notice that there was no sell signal between the March and July buy signals. The directional movement indicator calculations are complex, interpretation is straight-forward and successful implementation takes practice. Setting an ADX requirement will reduce signals, but this uber-smoothed indicator tends to filter as many good signals as bad.
In other words, chartists might consider moving ADX to the back burner and focusing on the Directional Indicators to generate signals. These crossover signals will be similar to those generated using momentum oscillators.
Therefore, chartists need to look elsewhere for confirmation help. Volume-based indicators, basic trend analysis and chart patterns can help distinguish strong crossover signals from weak crossover signals.
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