Best Trading Strategy Using Average Directional Index Indicator

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

In this article, we will understand the best trading strategy using the Average Directional Index to identify the strength of a trend.

What is Average Directional Index (ADX)?

The Average Direction Index is a technical analysis tool used to measure the strength and direction of a security’s trend. This indicator was developed by the famous American trader J. Welles Wilder, who also invented several technical indicators, including the Relative Strength Index (RSI).

The ADX indicator has three lines that help traders analyze whether a stock is in a trending or sideways market to formulate a potential trading strategy.

• The blue line is the ADX line, whose value defines the strength of the trend; higher ADX values ​​indicate a stronger trend.
• The green line is the Upward Movement Index (+DI), which measures the strength of the upward price movement. Higher +DM values ​​indicate greater price fluctuations.
• The red line is the Downward Movement Index (-DI), which measures the strength of the price decline. It’s on the other side of the green line.

ADX indicator parameters

• ADX greater than 25 indicates that the trend direction is quite strong.
• ADX less than 25 indicates an accumulation or distribution phase.
• ADX values ​​greater than 50 indicate a strong trend direction.

Best Trading Strategy Using Average Directional Index

The ADX line generates trading signals. As we learned, the directional movement indicators +DI and -DI help measure the strength of the trend direction.

bullish crossover

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

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

bearish crossover

When the negative movement index (-DM) line crosses the two-way movement index (+DM) line, it indicates that the negative price movement rate is higher than the positive price movement rate.

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

ADX with parabolic SAR

Parabolic SAR is a technical indicator that indicates the direction of a security’s trend. A series of dots above and below a candlestick indicate a downtrend and an uptrend respectively.

ADX used in conjunction with Parabolic SAR helps traders place long and short positions based on the security by determining the strength of the trend direction.

Here the ADX crossover provides the signal and the Parabolic SAR combines to check the signal.

• When the rising index line (+DM) crosses above the falling index line (-DM), it indicates an upward trend. Accordingly, when the parabolic SAR forms a series of points below the candle, it confirms a bullish trend to take a long position in the security.

• When the rising index line (+DM) crosses below the falling index line (-DM), it indicates a downtrend.

Accordingly, when the parabolic SAR forms a series of points on candles, this confirms a bearish trend taking a short position in the security.

ADX price difference

Divergence refers to a situation where a security and the ADX indicator move in opposite directions. This indicates that the current market trend is reversing. Here’s how to identify bullish and bearish divergences in the market.

bullish divergence

When the price of a security makes lower lows and the ADX indicator makes higher lows, this is a bullish divergence in the security.

This indicates that the bearish trend is weakening and indicates the possibility of a bullish reversal in the security’s price. When a bullish divergence occurs, it does not mean that the stock price will move in an upward direction. In this strategy, you should enter a buy position only when the +DM line crosses the +DM line.

bearish divergence

When the price of a security is making higher highs and the ADX indicator is making lower highs, this means a bearish divergence is occurring in the security. This indicates that a bullish trend is weakening and signals a potential bearish reversal in the security’s price.

Like a bullish divergence, the occurrence of a bearish divergence does not necessarily mean that the security will move in a downward direction. In this strategy, you should only consider entering a sell position when the -DI line crosses the +DI line.

conclusion

From the above learnings, you can understand that the best trading strategy using the Average Directional Index has a great impact in identifying the strength and direction of a trending market. Traders should analyze better entry and exit opportunity strategies with the help of ADX indicator for good profitability ratios.

To avoid false signals, traders are always advised to use the ADX indicator in conjunction with other technical tools to double check entry and exit opportunities.

Written by Deepak M

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