Technical indicators are much more than colored lines that intersect in your graphic. They are the tools that help us work in our trading operations. For this reason, we are going to analyze the indicator ADX (Average Directional Index) in depth.
What is the ADX’s origin?
This indicator was created by the currencies and commodities trader Welles Wilder, in his book "New concepts in technical trading" whose purpose is to identify whether there is a trend in a market or not and the strength of it.
To understand how the calculation of both directional indicators is formalized, first, we must explain the concepts DM (directional movement) and True Range (true range).
The DM is calculated by the difference of a maximum or minimum of the session about its maximum or minimum of the previous session, therefore in a bullish move we will obtain + DM (maximum difference), and in a bearish movement, we will obtain -DM (minimum difference).
How to use the ADX indicator as a trend filter?
As the ADX compares the differences between + DI and -DI are increasing it means that the market is in trend, and the ADX will reflect a positive slope, on the contrary, if between + DI and -DI there are hardly any differences, it will result in an ADX in negative slope, which means that the market is lateral without bullish or bearish dominate the market.
Traditionally if the ADX reflects readings higher than 40 is a sign of strength, on the other hand, readings below 20 reflect weakness in the market.
If you want to trade in the stock market following trends, you need to find movements that give you enough margins to be able to perform profitable operations. That is why it is necessary to filter.
According to Welles Wilder, in his book "New Concepts in Technical Trading Systems," a trend-following system should not be used when the level of the ADXR is less than 20. In this way, we block any input signal - long or short- of a trend system until you have the indicator ok.
Another tip that can be useful is to use the ADX indicator to filter, but do not use it to give signals because when looking to follow trends, it is better to use the ADX indicator to condition the entries to the market.
ADX is not as recommended to signal the outputs, why? Because the theory says that when the ADX goes down the trend is losing strength.
Very well, it may be losing strength but still be very profitable. For departures, it is preferable to use some trailing stop that allows you to take advantage of the trends and control the risk.
Why is it useful?
If you know how a technical analysis indicator is calculated, you will be able to know what it does and how it does it.
Once you know this you will be able to adjust it better to your type of operative, adjust the temporalities, to identify with what other indicators to combine it, and obviously you will be able to interpret your signals better.
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