Trading Trend Prediction; How Does the ADX Work?

Trading

During the second quarter of 2020, most of the world locked down and economies and stocks suffered. Yet the rebound in investment income was so good no-one could have predicted it. As leaders across the globe sought to stimulate economies so investors became considerably wealthier.

Though economies around the globe remain constrained as countries count the cost of the pandemic, many people now seek new investment opportunities.

As more people look to invest in stock, shares, commodities and cryptocurrency they will seek direction. Those who know how to use ADX can manage their financial assets knowing the likely direction the assets will take and so safeguard their investment.   

How does the ADX work?

The Average Directional Index or ADX is a trend oscillator. The ADX is based on a moving average over a specified period. It shows not just the trend but the strength of the trend too. The latter is a valuable determinant of whether this is the start of price movement or simply a price correction.

The ADX is suitable for tracking the movements of any financial asset.  

Once installed, the trend lines will appear below the candlestick price chart as three lines, the ADX line and the two directional movement indicators DMI. The index measures both upward and downward trends giving them the same value for similar strength. When the -DMI is higher than the +DMI prices are coming down and vice versa. In both instances, the ADX line measures the trend strength.

The indicator moves between 0%-100%. A value of less than 20% indicates an inconsequential price movement. Strong trends start at 40% and seldom go beyond 60%. Though many traders use 25 as the point at which trend trading strategies kick in.

Some words of advice

The direction of the ADX is also an important indicator. As it rises the strength of the trend increases. As soon as the ADX starts to fall in indicates decreasing trend strength. It does not mean that the trend is reversing rather that it is weaker.

A trader who knows that trend momentum is increasing can confidently leave his assets to grow and not exit the market when there is still money to be made.

Though the ADX is a powerful tool, the price as indicated on the candlestick chart is still most important. Traders must assess the price, its direction and the speed at which it is moving and only then consult the ADX.

Prices stay in the flat zone much of the time even though there may be quite steep prices up and down within the zone, forcing it out of the flat zone. If you depend on the movements of the DMI only, you may be tempted to act prematurely up to 50% of the time. You should take no action until the DMI lines cross and the ADX rises above 20.

The assets are likely overbought or oversold when the ADX breaches 50% so the price will probably start to decline quite rapidly. You should consider selling when the DMI lines start to meet.

Avoiding mistakes

Though the ADX goes a long way to ensuring that you know when to buy and sell, there are several other aspects that you should take care of

  • Start with a trading plan
  • Test your strategies on a demo platform. That way you can’t lose money
  • Avoid emotional trading
  • Stay within your planned budget
  • Use a stop-loss order
  • Avoid over-leveraging
  • Track your trades in a trade journal

Maximize your profits

Though some economists are convinced that the markets are overvalued and could come crashing down. The good news is that others believe that market values are in line with business value and interest rates.

Either way, you will receive the best return on your investment by using a combination of careful analysis along with the insights you get from the ADX and other technical tools.

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