Capturing Profits With the ADX

The Average Directional Movement index can help you decide when to exit.
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The Average Directional Movement index, or ADX, is an indicator that can help us as traders best determine profitable exit points. The ADX is a great long-term indicator and is best used with weekly charts. This indicator is readily available on virtually every charting package on the market.

A climb by the ADX line above 40, followed by a downturn, indicates an imminent end to the current trend. Using this rule, when the ADX line moves above 40 and then turns down, a trader should consider taking a profit. It doesn't matter if the primary trend is up or down. Once the ADX line turns down, that's a sign to exit.

While an ADX signal can indicate the end of an existing trend, a reversal in the trendline isn't necessarily the next step. Instead, prices may enter a consolidation phase and move sideways for a period of time.

The Average Directional Movement index isn't a helpful indicator during sideways markets. During an extended consolidation period, an ADX line can slip below 20 and even approach 10. When the ADX nears 10, a major move is usually about to take place. However, the ADX won't indicate which direction the move will go. You have to rely on other indicators for the probable direction of the next move.

The ADX can also be used as a filter, which isn't the same as an indicator that forecasts market direction. A filter helps weed out erroneous signals. A chart can indicate overbought or oversold positions for a long period of time, particularly during a strong trending market. To avoid selling or buying too soon, traders look at the ADX. As long as the ADX is rising, they stay with their positions. It acts as a filter to eliminate false countertrend signals.

Always remember that the ADX won't tell you when to re-enter the market or take a position in the opposite direction. You will need other indicators to do that. In addition, the ADX isn't a price-sensitive indicator, because it's looking at a 10-week period.

If you're interested in pinpointing the absolute tops or bottoms, the ADX will be sluggish and won't give you the best signals. It's a far better indicator for long-term moves, and used in this context it can be a very important technique in capturing large profits.

By Jeff Neal, contributing writer and options strategist at