Analysts have used technical indicators for years. They analyze historical data, looking at past price movements to speculate on the future price direction of financial instruments. These indicators rely on patterns and gather data from price, volume, or open interest.
It's crucial to understand that technical indicators work reactively; they don't predict the future but rather measure the risk and potential returns. This insight helps traders figure out the best times to enter or exit a trade.
In this article, we'll explore a less common technical indicator—the ADX indicator. ADX stands for Average Directional Movement Index. What makes this indicator impressive is its ability to spot stocks about to start a new uptrend, resulting in returns of 5 to 10 times their initial price. That's the secret of the ADX indicator—identifying stocks with strong uptrends.
This works especially well in bullish market conditions, where stocks can easily achieve returns of 100-1000x within months. Stocks like Pinterest, Snapchat, Fastly, and DataDog have all seen 5-10x returns when the ADX indicator was triggered on their charts (I encourage readers to backtest). If you had used the ADX, it would have correctly identified these stocks. Take a look at the chart below to see the ADX in action and get a sense of what we'll discuss in this article. By the time you finish reading, you'll see that the indicator is straightforward and easy to use.
How It Is Calculated
The indicator is used to measure the overall strength of a trend. The values used are usually adopted from the moving average of the prices of a security. The moving average indicator can be interpreted as when the prices are rising, they tend to pull the average prices of the security up creating an upward-sloping graph and vice-versa. This is the raw data that the ADX indicator uses to introduce two new lines +DI( Plus Directional Indicator) and –DI ( Minus Directional Indicator). ADX is calculated by taking the values of the DX divided by a specified period.
ADX Indicator Settings
The default configuration for the ADX indicator is 14 time periods, although many technical analysts frequently employ settings ranging from 7 to 30. Lower settings result in a more rapid response of the average directional index to price changes but are prone to producing more inaccurate signals. Thus, causing many "false" uptrends. I really recommend the reader to play and test their settings to see what their trading system is comfortable with.
How to Use The ADX Indicator
Wilder, the creator of the ADX indicator, suggests that a robust trend is evident when the ADX exceeds 25. Values below 20 usually don't provide a clear indication of a trend in either direction. When the trend shifts and starts descending, it signals the weakening of a strong uptrend, indicating it's prudent to consider closing your open positions (this serves as the sell signal). If the trend has been low for a while but suddenly the ADX rises from 15 to 30, it could be a signal to initiate a trade position (this is the buy signal).
To identify potential significant winners, I scan for stocks that experienced a substantial upward move, typically during earnings announcements (resulting in a 10-20% gap up on positive news). Focus on companies whose ADX, +DI, and -DI are relatively flat before the significant upward move. Then, look for the next few days where the ADX crosses 25, the +DI is relatively high, and the -DI is close to zero. This configuration suggests that the stock is consistently rising with minimal pullbacks, indicating a favorable buying opportunity. This methodology is the secret of the ADX indicator.
An example is Fastly ($FSLY) in the months between June and July, see the stock chart below with annotations. Where you see all segments of the ADX are relatively flat, then with impressive earnings report you see the ADX and D+ go above 25, while the D- rarely moves higher. This is exactly what you are looking for. Where it shows that the stock is in a very strong uptrend and is about to continue much higher! So you can see how the ADX is useful to identify stocks whose huge game-changing catalyst will catapult the stock for months to come.
In summary, the buy signal occurs when the ADX, +DI, and -DI of stock are relatively stable, and then, due to a fundamental shift in the stock, both the ADX and +DI experience a substantial increase, surpassing the 25 threshold. On the other hand, the sell signal based on the ADX is often challenging to determine precisely—it's more of an art form in deciding when to exit. Alternatively, one can employ mathematical strategies to minimize losses and maximize wins, such as converting profits to options or selling gradually when specific sell criteria are met.
Conclusion
Hopefully, by reading this article you have a good understanding of the secrets of the ADX indicator, understanding what a powerful tool it can be for trend traders. Using the ADX trading strategy listed above can often yield very large profits, but one must understand as quick as possible when the trend has changed or was a fake out.
These false signals or pivotal trend changes often occur during earnings reports, or macroeconomic effects, where something unexpected has changed. For example, massive inflation macroeconomically, or revenue growth failed to meet expectations due to various reasons. It's highly recommended to backtest and paper trade with this indicator until you are comfortable using it, with the ADX settings listed above.
If you are interested in learning more about other technical indicators with my style of trading take a look at The Art Of Mastering Japanese Candlesticks or an Introduction to the Relative String Indicator (RSI), or better yet my unique take on stock chart technical indicators.