Using technical analysis is the backdrop for stock trading along with the use of fundamental analysis to evaluate stocks and other securities. Traders use many technical indicators to identify stock trends and the momentum of the stock which is crucial information to take trading positions. ADX indicator is one of the many technical indicators often used by traders. Read on to know more on ADX indicator.
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What is the meaning of the ADX indicator?
ADX indicator was introduced by J Welles Wilder and is used to measure the strength of the trend in the financial market. This is usually a non-directional indicator which means it does not always show the direction of the trend clearly but merely measures the strength of the same. The ADX indicator is a single-line oscillator that reads between 0 to 100 and rises in case of a strong uptrend and falls in case of a strong downtrend.
The ADX indicator is made up of three lines namely the ADX line, the Positive Directional Indicator (+DI) line, and the Negative Directional Indicator (-DI) line. The ADX line is the primary line, and it shows the strength of the trend. On the other hand, the other lines, +DI and -DI, show the direction of the trend. The +DI and -DI lines can be used to determine the direction of the trend. If the +DI line is above the -DI line, it suggests an uptrend. Similarly, when the -DI line is above the +DI line, it can suggest a downtrend.
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How to use the ADX indicator for day trading?
Day traders can use ADX (Average Directional Index) indicator to identify potential trend reversals or confirm the strength of an existing trend. Traders can use the ADX Indicator in the following manner.
- Identifying strong trends
Day traders can use the ADX to identify strong market trends. An indicator above 25 is generally considered to indicate a strong trend. Traders can therefore use this indicator to look for opportunities to enter trades in the direction of the trend.
- Look for crossovers
Day traders can also use the +DI and -DI lines to identify potential trend changes. The market shows an uptrend when the +DI line crosses above the -DI line and a downtrend when the -DI line crosses above the +DI line.
- Identifying potential trend reversals
The ADX indicator can also be used to stop trend reversals. A falling ADX line may suggest that the trend is weakening and a potential reversal is on the horizon. Day traders should also look for other technical indicators (moving averages or candlestick patterns) to confirm a potential trend reversal. Traders can subsequently enter a trade in the opposite direction to maximise their returns.
- Risk management
ADX indicator can also be effectively used for risk management. Traders can use the falling ADX line as an indicator of a weakening trend. Traders can therefore exit their trading positions or reduce their position size to avoid potential losses.
What are a few weaknesses of the ADX indicator?
A few limitations of using the ADX indicator are mentioned hereunder.
- Lagging indicator
This indicator is a lagging indicator and is used to identify trend changes. But being in the nature of a lagging indicator, it is generally slow to respond to dynamic market changes and therefore may not reflect the accurate market conditions. This indicator may also lead to false signals.
- Lack of any price information
This indicator is used to get information on the trend alone. There is no information on the stock or the security prices. Therefore, traders need to rely on supplementary indicators and tools to identify entry and exit points.
- Not ideal for all market conditions
ADX indicators work in the case of trending markets. Therefore, in case the market is moving sideways and is not showing any clear direction, the ADX indicator may not be as useful for traders and may generate false signals which can result in losses for the traders.
- Not ideal for every trader
This indicator may not be ideal for every trader as there can be different trading styles. Traders who prefer looking for trading opportunities through breakouts may not get much information through ADX indicators.
ADX indicators are useful to indicate the strength of the indicator. It is not a perfect tool for identifying trend direction as can sometimes be slow to respond to changes in trend direction. Therefore, it is possible that the ADX indicator may generate false signals in markets that are moving sideways or in a range. Traders can hence use the ADX indicator along with other technical indicators to have a better and clear analysis of the market condition.
The ADX indicator between 0-20 indicates a non-trending stock, the ADX indicator between 20-45 indicates a strong trend, the ADX indicator between 45-60 indicates a very strong trend while an indicator over 60 indicates an extremely strong trend.
ADX indicator is based on past prices and moving averages and therefore is known as a lagging indicator
The ADX indicator up to 20 indicates that the market is range bound and has a sideways price action.
The RSI Indicator can be used in correlation with the ADX indicator for a better understanding of the market. The ADX indicator is used to measure the trend momentum while the RSI indicator can be used to identify the entry and exit points for the security.