Trading the ADX Indicator
Two elements to the ADX indicator that help determine whether the market is trending up or down are plus directional movement (+DM) and minus directional movement (–DM). These two elements indicate trend direction:
When +DM is above –DM, trend is up.
When –DM is above +DM, trend is down.
ADX measures the strength of either the uptrend or downtrend.
One approach for trading the ADX indicator is to wait for ADX to get above a value of 25 (or 20 if you want to be more aggressive) and then buy when the +DM line is above the –DM line. The figure illustrates an example of this (ADX is the thickest line, +DM is the second thickest line, and –DM is the thinnest line).
Shorting the market involves waiting for the ADX to get above a value of 25 (or 20 if you want to be more aggressive) and then short when the –DM line is above +DM line. The following figure illustrates an example of this short signal.
Although the ADX indicator is a popular tool and can be used effectively, after the ADX line crosses above 25, it often moves back against the direction of the trend while the price bars continue in the direction of the trend. When this occurs, it’s not a clear signal whether the trend is reversing, simply slowing down, or consolidating. Therefore, it’s very difficult to use it in determining when the trend is ending.
To further complicate matters, an uptrend can turn into a downtrend as seen on the price bars. But it won’t be signaled on the ADX indicator until it returns all the way back down to 25 and then crosses above it, thereby giving a very late signal for trend reversals, or even trend continuations.