Best Trading Strategies Using Average Directional Index: In the evolving financial markets, traders constantly seek reliable technical tools to learn the complexities of price movements. Among various technical analysis indicators available, one such tool used to understand the strength of a trend is the Average Directional Index indicator(ADX).

In this article, we shall understand the Best Trading Strategies Using Average Directional Index to identify the strength of trends.

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What is the Average Directional Index(ADX)?

Average Directional Index is a technical analysis tool that is used to measure the strength and direction of a trend in a security. The indicator was developed by a famous American trader J. Welles Wilder, he has also invented several technical indicators including the relative strength index(RSI).

ADX indicator comes with three lines that help traders analyze whether the stock is in a trending or sideways market to build potential trading strategies. 

  • The blue line is the ADX line where its values define the strength of the trend and the higher the ADX value, the stronger the trend.
  • The green line is the positive directional movement index(+DI), which gauges the strength of the upward price movements. Higher values of +DM indicate a higher price movement.
  • The red line is the negative directional movement index (-DI), which measures the strength of downward price movement. It is opposite to the green line.
Best Trading Strategies Using Average Directional Index

 ADX Indicator Parameters

  • When the ADX is greater than 25, it indicates a fair strength in the trend direction.
  • When ADX is less than 25, then it indicates an accumulation or distribution phase.
  • When the ADX value is greater than 50 it indicates a strong strength in trend direction.

Best Trading Strategies Using Average Directional Index

The ADX line generates trading signals. As we have learned both the directional movement indicators +DI and -DI helps to gauge the strength of trend direction.

Bullish Crossover

When the positive directional movement index(+DM) line crosses above the negative directional movement index(-DM) line, it indicates that the rate of positive price change for the security is greater than the rate of negative price change.

Here, if the ADX line is above the 25 mark with a bullish crossover, then it is a strong buy signal, and traders can take a long position in a security.

Bullish Crossover

Bearish Crossover

When the negative directional movement index(-DM) line crosses over the positive directional movement index(+DM) line, it indicates that the negative rate of price change is higher than the positive rate of price change.

Here, if the ADX line is above the 25 mark with a bearish crossover, then it is a strong sell signal and traders can take a short position in a security.

Bearish Crossover

ADX with Parabolic SAR

Parabolic SAR is a technical indicator that indicates the trend direction of securities. A series of dots above and below the candlesticks signals a downtrend and uptrend respectively.

ADX used with Parabolic SAR determines the strength of trend direction, which helps traders to place long and short positions accordingly in security. 

Here, ADX crossover provides signals and Parabolic SAR combined confirms the signal.

  • When the positive directional index line(+DM) crosses above the negative directional index line(-DM), it indicates an uptrend. Correspondingly when the parabolic SAR forms a series of dots below the candlesticks, it confirms the bullish trend to take a long position in a security.
Best Trading Strategies Using Average Directional Index-Parabolic SAR
  • When the positive directional index line(+DM) crosses below the negative directional index line(-DM), it indicates a downtrend. 

Correspondingly when the parabolic SAR forms a series of dots above the candlesticks, it confirms the bearish trend to take a short position in a security.

Best Trading Strategies Using Average Directional Index - negative directional index

ADX Price Divergence

Divergence refers to a situation where the security and ADX indicators move in opposite directions. This is an indication of the reversal from the current trend in the market. Following are the ways to Identify bullish and bearish Divergences in the market.

Bullish Divergence

When the price of the security is making lower lows and the ADX indicator is making higher lows, it is an occurrence of bullish divergence in the security.

This indicates that the bearish trend is weakening and signals a potential bullish reversal in the price of the security. The occurrence of bullish divergence doesn’t imply that security will move in the upward direction. One should only enter a long position in this strategy when the +DM line crosses above +DM line.

Bullish Divergence

Bearish Divergence

When the price of the security is making Higher Highs and the ADX indicator is making lower highs, it is an occurrence of bearish divergence in the security. This indicates that the bullish trend is weakening and signals a potential bearish reversal in the price of the security.

Similar to Bullish Divergence, the occurrence of bearish divergence doesn’t necessarily imply that the security will move in a downward direction. One should only consider entering a short position in this strategy when the -DI line crosses above the +DI line. 

Bearish Divergence

Conclusion

From the above learnings, it can be understood that the Best Trading Strategies Using Average Directional Index have a great impact on identifying the strength and direction of trending markets. Traders should analyze the strategies for better entry and exit opportunities with the help of an ADX indicator for good profitable ratios.

It is always preferred that traders should always use the ADX indicator in conjunction with other technical tools for double confirmation of entry and exit opportunities to avoid false signals.

Written By Deepak M

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