- The Average Directional Index is a technical indicator used to analyse the stock market.
- The ADX indicator is used to assess the strength of the trend. However it is used in conjunction with two other lines +DI (positive directional indicator) and -DI (negative directional indicator) which decide the direction of the trend.
- Traders can use these lines together and decide whether to enter the trade or not. Also if they enter the trade, whether to go short or long in the rally.
Few formulae for ADX indicator:
Generally, the number of smoothing periods considered are 14, i.e., n = 14
- The ADX indicates a strong trend when the value is above 25 and it indicates a weak trend when the value is below 20.
- The trend direction can be identified from the crossovers between +DI and -DI.
- If +DI crosses above -DI and if the ADX value is above 25, it indicates a strong buy signal and traders can go long in the rally.
- Few traders who already went short in the rally can initiate their short coverings.
- Similarly, if the -DI crosses above the +DI and if the ADX value is above 25, it indicates a strong sell signal and traders can go short in the rally.
- Few traders who already went long in the rally can initiate their long unwinding.
- Traders should never enter the trade when the ADX value is below 20 because it indicates a weak strength and the price is trendless.
- The main disadvantage of the ADX indicator is that crossovers occur frequently. They can act as false signals especially when the ADX value is below 25 and it puts the traders in a dilemma whether to go long or short in the rally.
This is the 1 day chart of Tata Steel Ltd (NSE) around Nov, 2019 to Aug, 2020.
ADX – violet line, +DI – green line, -DI – red line