Using ADX Indicator Strategy to Identify Price Trends

When a financial trader watches his security go up in price but then settle back down by two-thirds, the real question he wants to answer is whether prices are just pulling back en route to higher places, or whether they have turned around in earnest and will keep falling. Since both of these outcomes tend to manifest at times, it’s difficult to tell which one is about to happen. If it were easy, most traders would be rich and long retired!

Big wave surfers face a similar dilemma. After they catch a monstrous wave, the question is whether more are on the way, or whether this one was a once-time event. Here, they can turn to weather forecasting technology, which measures factors like the wind’s fetch (how far it has blown over the open seas before reaching shore) and can also identify storm systems at work behind the scenes. If both these elements are in place, the surfer has strong reason to believe his wave wasn’t just a once-off, and he can confidently paddle out again to wait for the swell to arrive.

Is there something similar to this technology in the field of financial trading – something that can indicate whether more bullish waves are on the way, or whether they’re tapering off? The good news is that there is. Traders using online brokerage platforms enjoy the use of a variety of technical trading tools, some of which are designed to capture potential trends in the market. Trend traders use these tools to analyse the momentum of their assets’ price movement in a particular direction.

MACD

An example is the MACD (moving average convergence divergence) indicator. This handy tool takes moving averages (constantly refreshed average prices for a security) and uses them to gauge the magnitude of trends in either an upward or downward direction. It also helps evaluate the momentum of price movement in that direction. If you see the MACD lines on your chart remain above zero for a considerable period, there is likely an uptrend at work, which makes for a buy signal. But when the lines remain below zero for some time, you may have a downtrend on your hands, which would be a signal to sell.

No single technical indicator is airtight and foolproof, and MACD indicators are no exception. Beleaguered traders have complained of the tendency of the MACD to send out false buy signals, but also to miss out on big price reversals. When there is no trend guiding the market, moving averages are notorious for sending out unreliable signals. Rather than discarding the MACD, traders have responded by combining it with another technical indicator called ADX (average directional index). The specialty of the ADX is in unearthing hidden trends driving price activity beneath the surface and on a larger scale.

What is the ADX Indicator?

Generally speaking, the opportunities available when trading conditions are trending are much better than when they are not. If prices are trending, it means, not just that they are, (in a bull market), going up, but that they are tending to continually go up. The MACD can indicate when this is happening by showing us that average prices are heading up. ADX uses moving averages in a different sort of way to give us the same insight, but it also tells us which are the stronger trends at work, and which are the weaker. This information is worth its weight in gold to financial traders, (or would be, if it had any weight).

Take a look at this price chart with the orange ADX indicator doing its job underneath:

As you see, prices continually drive higher during the period in question. For a start, note that prices themselves indicate there is a bullish trend at work here. But what’s going on below? What we see there are the oscillations of the ADX indicator above and below the 25 mark, which is a particularly significant level to watch. Technical analysts believe that ADX readings above 25 suggest a strong trend is present, with the strength of the trend increasing as the ADX figure goes up. By contrast, when the ADX reading dips below 25, the viability of trading on trends starts to lessen.

When you see the ADX is falling in the graph above, it does not mean the trend is reversing. This is clear because when the ADX goes for its first serious dip, the upward price trend continues above. In fact, as the ADX begins to oscillate up and down after that, we see the bullish trend just keeps on going, oblivious of what’s going on below. So, what is the ADX indicator telling us?

The answer is that it’s telling us something of great importance for any trader who has an open buy position in this market. Notice that the three ADX peaks descend in height, one after the other, even though they all stay above 25. The high number means there is an upward trend to speak of at all three peaks, which is reason to believe prices will keep rising (and we see, in fact, that they do). However, the descending peaks mean that the momentum of the bullish trend is consistently weakening with the passing of time.

We have no clear indication of when prices will reverse and, indeed, they might continue upward for some time. But the ADX indicator is definitely telling us to start allowing a reversal to enter under our radar. One practical thing this means is to start managing risk appropriately. We have substantial reason to believe prices are going to, sooner or later, take a dive. There’s nothing that indicates this from the prices themselves. Indeed, if the price chart looked identical but the ADX indicator showed a series of rising peaks instead of falling peaks, we would know trend momentum was increasing, and this would be reason enough to let your buy position ride.

How to Use the ADX Indicator

Read the ADX Indicator as an explainer of your price chart data, rather than in isolation. Don’t forget that prices themselves are teaching you something about potential trends in the making. Let’s say you see prices break out into a bullish run. There’s no way of knowing, just from the price chart, whether this run will turn into a stampede or whether it will lead to a dead end, with the bulls soon returning with their tails between their legs. That’s when the ADX indicator enters the scene and gives you a series of readings leading up to the bull run. If you see ADX languishing down in low numbers like 17 and 18, you should beware of that quick retreat, because it may materialize very soon. If, on the other hand, ADX is holding at a solid 40, you might want to open a buy deal here. If you already have, you can drink a martini and rest assured that things are looking promising.

ADX also gives you an idea about the conditions ruling the market at a given time. Traders view a prolonged ADX reading of less than 25 (for 30 bars or more) as a sign that prices have entered range conditions. This means that, instead of being driven by a bullish or bearish trend, they are oscillating within a certain range of prices, from which they are struggling to break out. Knowing this is the case helps traders avoid trend-trading strategies when prices are going sideways. Perhaps you know the frustration of trying to surf a series of tiny waves that never amount to anything.

Not to worry though, because it usually doesn’t take long for a new price trend to brew. Indeed, these more stagnant conditions often foster the emergence of the best trends of all. And remember that trends make themselves known, not only in the short-term, but also in the mid- and long-term.

Wrapping Things Up

Why not do some research about some of the other technical indicators out there like, for instance, the RSI (relative strength indicator), which measures how overbought or oversold a security may be? This is another one of the aids made to assist you in discovering the benefits of trend-trading.

As your research continues, you may develop a special connection with one of the indicators, in which case you should develop this connection and become the real expert in the field. After all, the aim is for you to find trading strategies that work for you, not other people. Finally, it’s a good idea to try out trading with the ADX indicator using iFOREX’s free demo account. This way, you can get the hang of things before you actually go out there and trade with your real funds.