Many traders have found success through trend trading—establishing a position when the market makes an extended move either up or down and hanging on for the ride—but during times of sideways price action, trend strategies can be the source of many losses and much financial pain. It’s important for trend traders to hold off trading markets when those markets lack clear and consistent directional movement.

The average directional index, or ADX, is a popular tool for measuring trend strength and letting you know when to stay out of the markets. An element of the Directional Movement System that was popularized in the 1970s and 1980s by famed technician Welles Wilder, it is one way to determine if a security is trending in a potentially profitable way. When combined with the DI+ and DI– the ADX also can generate buy and sell signals.

The ADX indicator has long been in the public domain, and it’s a common feature of nearly all technical trading and charting software, so its calculation will not be covered here. However, the math is readily and freely available online.

Interpretation
The ADX shows trend strength, not direction. The main purpose of the ADX is to determine whether a market is trending or is in a trading range. Determining which mode a market is in is helpful for traders. The first concept to remember is that the direction that the ADX moves doesn’t depend upon the direction of the underlying stock. This means:  A strong upward trend = Increasing ADX and a strong downward trend = Increasing ADX

Further, a number of parameters have been developed by technical traders over the years that can be used to hone the application of the indicator:

• ADX value below 20: Non-trending market.
• ADX crosses above 20: Signal that a trend might be emerging; consider initiating buy or sell short in direction of prevailing stock, futures or currency price movement.
• ADX value drifting between 20 and 40: If ADX is increasing between 20 and 40, then it is further confirmation of emerging trend. Buy or short sell in the direction of the current market direction. Avoid using oscillator technical indicators, such as the RSI, and use trend-following indicators, such as moving averages.
• ADX above 40: Strong trend.
• ADX crosses above 50: Extremely strong trend.
• ADX crosses above 70: A “power trend” is in place; this is a rare occurrence for any market.

“Trend view” (below) shows the ADX with a price chart of the S&P 500 (CME:SPZ14). It is a good example of the ADX in action. As seen in the chart, the S&P 500 was in a strong uptrend and the ADX was rising steadily, When the S&P 500 moved in non-directional consolidation phase,  the ADX crossed below the 40 line, suggesting the trend was over by registering a decreasing ADX.

The Directional Indicator, or DI, Crossover System involves comparing the 14-day DI+ and the 14-day DI–. The DI+ and DI– are components of the ADX itself. This strategy can be implemented by plotting the two indicators on top of each other or by subtracting the DI+ from the DI– and observing the net value of the result. 

Wilder suggests two rules for trading ADX using the DI Crossover System:

• Buy when the DI+ rises above the DI–
• Sell when the DI+ falls below the DI– 

Setting filters

In “Timing trends” (below), we chart the DI+ line (blue), the DI– line (red) and the ADX (green). However, it’s important to realize that not all crosses of the lines are equal. If you trade on all of them, you will certainly establish a lot of losing trades. To address this, Wilder qualifies his simple trading rules with the “extreme point rule.” This is designed to prevent whipsaws and reduce the number of trades. The extreme point rule requires that on the day that the DI+ and DI– cross, you note the “extreme point,” as follows: 

• When the DI+ rises above the DI–, the extreme price is the high price on the day the lines cross. 
• When the DI+ falls below the DI–, the extreme price is the low price on the day the lines cross. 

Rather than buying on the cross itself, the extreme point becomes the trigger point at which you should implement the trade.

To buy after receiving a buy signal (the DI+ rises above the DI–), you should then wait until the security’s price rises above the extreme point (the high price on the day that the cross occurred) before buying. If the price fails to do so, you should continue to hold a short position or remain flat. To sell after receiving a sell signal (the DI+ crossing below the DI–), you should then wait until the security’s price falls below the extreme point (the low price on the day that the cross occurred) before short selling. If the price fails to do so, you should continue to hold your long position or remain flat.

“Going long” (below) includes a chart of Apple, along with the ADX indicator. It demonstrates how to initiate a buy trade. On Dec. 19, 2011, Apple made a low of $387, and a high of $396 the same day the DI+ line (blue) crossed the DI– line (red) to the upside, signaling a buy setup. Confirmation will come when the extreme point is crossed and sustained. The extreme point in this case is the $396 high on Dec. 19, marked with a yellow circle.

On Dec. 21, Apple breaks $396, permitting traders to initiate the buy trade. A stop loss can be kept at the lowest low of the previous two days low, which is $387. The trader can ride the rally until the ADX close below 40, as indicated in the chart. As discussed, an ADX below 40 signals a non-trending market. The ADX closed below 40 on April 18, 2012, when traders following this method would have closed the position at $608. In this case, the ADX helped to gain almost $212 points, riding a rally from $396 to $608 in a matter of four months. 

Let’s analyze the chart for Caterpillar Inc. (see “Going short,” below) to understand how the ADX generates a short sell trade. On Feb. 7, 2013, Caterpillar made a low of $95.20 and a high of $97.40 when the DI+ line (blue) crossed the DI– line (red) to the downside, signaling a sell setup. Confirmation will come when the extreme point is crossed and sustained. In this case, that point is the Feb. 7 low of $95.20.

On Feb. 19, Caterpillar broke $95.20 and traders following this system were free to initiate the short trade. A good stop loss can be maintained at the high of the previous two days, which is $97.50. As with the long Apple trade, it’s advisable that the trader ride the trade until the ADX closes below 40. The ADX does so on April 23, 2013, when traders would have offset the position at $84. For this trade, traders make almost $9, as the stock moved from $95 to $84 in matter of two months. 

The ADX indicator interpretation is fairly straightforward, both as a filter and as a source of signal generation. The DI+ and DI– crossovers are frequent, and technical traders need to filter these signals with complementary analysis. In addition to the extreme point requirement, it’s suggested that traders consider volume-based indicators, basic trend analysis and chart patterns to help distinguish strong crossover signals from weak ones.

Bramesh Bhandari writes at www.bramesh-techanalysis.com and provides online tutoring on technical analysis. He can be reached via e-mail at bhandaribrahmesh@gmail.com.