How to Use the Average Directional Index Indicator
The ADX Indicator helps stock traders (as well as traders and investors in general) determine how strong the trend is, whether it be up or down.
The lack of strength in the indicator can be used to signal a non-trending security, or sideways, trading-range movement.
If you're a swing trader or long term investor, using this type of indicator as part of your technical analysis can help to prevent from entering a new long position into weak trending stocks that may be losing momentum and potentially be on the brink of reversing.
The same goes true where this signal can be useful to avoid entering new short positions into weak trending stocks, only in reverse, into weak downtrends.
In addition, there's no reason to enter new positions into a sideways, trading-range bound stock knowing that it could be months before a breakout or reversal occurs. This is when time could be better spent doing research looking for better opportunities.
Since this indicator measures the strength of a trend, it cannot be used alone for buy or sell signals, only in conjunction with other indicators to help select stocks for further analysis.
You'll find that many charting programs display the ADX along with 2 other lines referred to as +DI and -DI (DI= Directional Indicator). Some people use these additional indicators when looking at the ADX and some pay no attention to them at all. As with any technical analysis, you'll have to do some testing and see what you prefer to use.
In the example below, you'll see the ADX Indicator along with the +DI and -DI displayed below the main chart area (some charting programs will allow you to display these above or below the main chart area).
The black line is the ADX Indicator, the green line is the +DI and the red line is the -DI (all below the main chart area). Many people use 20 as the level of either trending or not (some use other numbers such as 25, 30 or even 40). For example, if the ADX crosses above the 20 level from below, the trend is gaining strength. If the ADX crosses below the 20 level from above, the trend has become a sideways, trading range.
In the example chart above, you could have combined signals from the ADX and the +DI and -DI to help pinpoint turning points in the trends based on increasing strength occurring at reversals. (a little more intricate than some basic possibilities using the ADX).
In the example below, back in May, 2010 and December, 2010, the ADX crossed above the 20 level from below both times signaling an increasing strength in the trend, both providing good trading opportunities if the stock met your other criteria for a stock pick.
When looking at the ADX Indicator, keep in mind that extreme highs or lows often occur at or near reversals. You can look at the past performance of the existing stock to see where these extremes have historically been as a guideline. Remember that guidelines can be wrong during extreme economic times though...