We all have that friend who is on top of all the latest trends. Their clothes are always in style, they have the latest smartphone in their pocket . . . and they somehow know about that new trendy restaurant in town before anyone else does. Seriously, how do they know that?
While it might be nice to know what the hottest trends in fashion and music are, what if there was a way to figure out which investments are trending up and which ones are on the way down? That’s where the ADX—also known as the Average Directional Index—comes in.
What Is the ADX?
The ADX is a tool or indicator used by some investors (especially those who dabble in buying and selling stocks through day trading) to measure the strength of an investment trend. For traders who buy or sell investments based on trends, the ADX is a tool that can help signal whether it’s time to buy, sell or hold on to that investment, hypothetically.
It’s important to remember that the ADX indicator doesn’t tell you what direction an investment’s price is moving. The ADX just tells you how strongly that investment is moving in a particular direction—whether it’s up or down. For example, if a stock’s price is rising, the ADX can give you an idea whether or not it’s likely to continue rising or if it’s about to start dropping.
The ADX can be used to measure the trend strength of basically any investment you can trade, including single stocks, mutual funds and exchange-traded funds.
What You Need to Know About the ADX
When the price of a stock or mutual fund goes up or down, the ADX indicator tries to measure how strong that movement is using something called directional movement indicators (DMI).
That’s why an ADX graph is usually made up of three indicator lines—the ADX line and two DMI lines (+DMI and -DMI)—that you will see on a chart right underneath a stock or mutual fund’s regular price chart. The value of the DMI and ADX lines can be anywhere between zero and 100.
Let’s break down each of those three lines so you know what you’re looking at:
- Positive Directional Movement Indicator (+DMI): This line shows how strongly the price of an investment is moving upward by looking at the daily high prices of that investment over the past 14 days.
- Negative Directional Movement Indicator (-DMI): This line does the opposite. It shows how strongly an investment’s price is moving downward by looking at its daily low prices over the past 14 days.
- Average Directional Index (ADX): Like we mentioned earlier, the ADX’s job is to tell how strong that investment’s price movement really is—whether it’s up or down. The ADX doesn’t tell you which way a stock’s price is moving. It just tells you how strong that movement is.
Here’s an example of what those three lines might look like on a graph:
You’re probably thinking to yourself, How do I make sense of all these lines on this graph? Don’t worry, we’ll walk you through some things to keep in mind when you’re looking at the ADX:
- First, you need to look at the DMI lines to see which way your investment’s price is moving. If the +DMI line is above the -DMI line, then the price of that investment is probably rising. And if the -DMI is above the +DMI, that means the investment’s price is probably dropping like a rock. Makes sense, right?
- Once you’ve figured out which way a stock’s price is going, it’s time to look at the ADX line. Again, this line shows how strong the trend is. According to Welles Wilder—he’s the analyst who developed this system—whenever the ADX is above 25, that means it’s a strong trend. So if you see that the +DMI is higher than the -DMI and the ADX is 35, then that means the price of that investment has a strong upward trend.
- Any ADX below 25 means that it’s either a weak trend or there’s no trend present. Whenever the ADX is below 25, the price of the investment will likely remain steady within a certain price range—there won’t be much upward or downward movement.
- If the ADX starts to drop, that could be a sign that the trend could be coming to an end or is at least weakening in strength. And if the ADX is starting to go up, that means there’s a chance that a trend is about to form or is getting stronger.
How Does the ADX Work?
Let’s look at an example to see how a stock trader might use the ADX indicator to make investing decisions.
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Meet Lionel. Lionel owns several shares of stock in a company, and he sees that the stock’s price has been rising a lot over the past month. Now he’s wondering if he should sell his shares now or if he should hold on to them for a little while longer.
To help him decide, he takes a look below the stock’s price chart, which shows its ADX. He sees that the stock’s +DMI is above the -DMI and the ADX is currently at 45. That means that the stock’s upward trend is very strong and its price is likely to continue rising (for now), so he decides to hold on and let the profits keep on running.
A couple of weeks later, the ADX quickly drops below 25—which marks the end of the stock’s upward trend. Soon after that, the -DMI line crosses above the +DMI line and the ADX shoots up above 25 again, which means that the stock is about to go on a sharp downward trend. At this point, Lionel decides that now is the time to sell his shares before the stock’s value drops too far.
Is Investing Based on Trends a Good Idea?
Okay, let’s take a timeout here to emphasize that trying to “time the market” based on trends is a dangerous game. It’s a short-term perspective to investing that will leave you anxious, stressed out and burned out in no time.
At the end of the day the ADX can only tell you so much about an investment. And sometimes trends happen so quickly that the ADX is slow to catch them or winds up giving false signals, so it’s not a foolproof method of measuring an investment trend.
And the truth is most stock traders who try to buy and sell stocks on a daily basis lose money and quit within two years of trading.1 Most successful investors—the ones who go on to become millionaires—take a much different approach.
According to The National Study of Millionaires, eight out of 10 millionaires say investing in their employer-sponsored retirement plan was the biggest factor in reaching their seven-figure net worth. They weren’t glued to their computer screens every day looking for the next trendy single stock to trade. In fact, not a single one of them put single stocks in their top three wealth-contributing factors.
That’s why we recommend investing 15% of your income in tax-advantaged retirement accounts like your 401(k) and Roth IRA. And when you spread out your investments across these four types of good growth stock mutual funds—growth, growth and income, aggressive growth, and international—you’ll have a diversified portfolio that lowers your investment risk.
Work With a Financial Advisor
The great news is you don’t have to figure this all out on your own! With the SmartVestor program, you can get connected with several qualified financial advisors in your area who can help you set up a plan for investing. That way, you set yourself up for the retirement you’ve always dreamed of!
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.