Market Trend Indicator: Details on ADX Indicator and Bollinger Band

In today’s modern markets, relying solely on fundamental factors to make investment decisions may not be enough. Markets move rapidly and can be influenced by a multitude of factors right from market sentiment to economic data or geopolitical events. 

Amidst this complexity, it becomes critical to understand what a market trend means. 

Think of a trend as the general direction in which the markets or an asset move. Now, this direction can be upward, downward, or sideways. For instance, a market may move ‘upward’ on positive news or crash (read downward) on negative news.  

You see, these market movements or what we call ‘trends’ can be analysed and predicted using trending indicators. But how do trending indicators work? Which are the best-trending indicators? 

In this chapter, we explore different types of trending indicators and how you can deploy them to your advantage. 

Understanding Trending Indicators

Trending indicators, as the name suggests, are indicators that help identify, analyse and predict the trend and behaviour of various markets, stocks, currencies and commodities. In simpler terms, trending indicators are tools that help track the direction and strength of a price movement over a specific period. 

These indicators also help identify whether the market is experiencing a bull run, bear run or moving sideways. A trader can deploy trending indicators to gain valuable insights, analyse risk and spot potential market opportunities. 

The most commonly used trending indicators are – Moving Averages, ADX (Average Directional Index), Bollinger Bands, RSI (Relative Strength Index) and MACD (Moving Average Convergence and Divergence). 

However, do remember that even the best trending indicators are not foolproof. Therefore, it's wise to use these indicators in conjunction with other analytical tools and market knowledge to make well-rounded investment decisions. 

We have already covered ‘Moving Averages’ in our previous chapter. This chapter will explore the ADX indicator and Bollinger Bands in detail.

ADX

The ADX or Average Directional Index, along with the Positive Directional Indicator (+DI) and Negative Directional Indicator (-DI), constitute a set of directional, short-term lagging indicators devised by Welles Wilder. He introduced the indicator in 1978 in his book, New Concepts in Technical Trading Systems, and despite being decades old, it finds relevance in today’s market. 

Fun fact: The ADX indicator was originally tailored for the commodities market as Wilder was a commodity and currency trader. His book has examples from these markets and not the regular stock markets!

The ADX is calculated to gauge the strength and direction of the trend, analyse the start and end of a bull or bear run, identify weakening and strengthening positive and negative trends, and generate buy and sell signals. 

The ADX is derived by smoothed averages of the difference between the +DI and -DI values over a period. +DI and -DI are determined by considering two consecutive lows and the difference between respective highs (we’ll discuss this more in detail below).

And, just like many other indicators, the ADX fluctuates between 0 and 100 and can be applied to any market conditions, such as bear and bull runs, different volatilities, and more. 

Take a look at this image to understand ADX, +DI and -DI better –

Let’s see how the ADX, +DI and DI- are calculated step-by-step.

ADX Calculations 

1. You will first calculate the true range (TR), +DM and -DM for a period of 14 days. True range is the greater of current high minus current low, current high minus previous close, or current low minus previous close.
2. +DM and -DM values are then calculated using current highs and lows and previous highs and lows. +DM is when current high minus previous high > previous low minus current low. -DM is when the previous low minus current low is >current high minus current low. Once done, you will need to apply Wilder’s smoothing techniques to the values obtained. 
3. Next, you will derive the 14-day smoothed +DI14 by dividing the smoothed +DM by the smoothed true range and multiplying it by 100. Same way, you will obtain the 14-day smoothed -DI14 by dividing the smoothed -DM by the smoothed true range and multiplying it by 100. 
4. Now, you can calculate the directional movement index (DX) by dividing (+DI14 - (-DI14)) with (+DI14 +(-DI14)) and multiplying it by 100. Think of it this way –

DX =DI14 Difference/DI14 Sum*100

1. Now ADX = Simple average of DX for a 14-day period

Subsequent values = ( (First ADX value *13)+ Current DX)/14

ADX Interpretations

ADX, always used in context with +DI and -DI, oscillates between 0-100 though it may rarely cross the 60 mark. Here’s a simple table to help you understand how to interpret the ADX indicator –

Indicator	Below 20	Above 20	Above 40	Below 40 and falling
ADX	Trading range	New trend emerging	The trend is strong	The trend is weakening
+DI	Bullish trend (weak)	Bullish trend emerging strongly	Very strong bullish trend	The bullish trend is weakening
-DI	Bearish trend (weak)	Bearish trend emerging strongly	Very strong bearish trend	The bearish trend is weakening

 

Besides this table, here are some points you must remember when dealing with the ADX indicator. 

• If +DI crosses -DI, it is indicative of a bull run or a buy signal; if -DI crosses +DI, it is indicative of a bear run or a sell signal. 
• Most analysts take a reading of above 25 as indicative of a strong trend and anything below 20 as no trend.  A rising ADX is indicative that a trend is strengthening. Conversely, if the ADX line is falling, it could indicate that the trend is weakening.
• Only in absolutely rare events will the ADX cross or touch the 60-100 levels.
• ADX indicator is also a popular range determinant. If the ADX is, say, below a certain level, the market can be considered range-bound (lack of trend or bound).  Range-bound markets often break out, but many times, it may be false. ADX can help validate not just trends but also range. 

Now, let’s move to another set of lines and bands – Bollinger Bands.

Bollinger Bands

Introduced by John Bollinger in the 1980s, Bollinger Bands (BB) combine the concept of market volatility and moving averages in one indicator to help identify potential buy and sell signals.

The Bollinger Bands are a type of technical indicator that consists of three lines plotted on a price chart. These 3 lines together create a price channel and can be customised to different periods and standard deviations.

The middle line represents the moving average (typically a 20-day simple moving average), while the upper and lower bands are placed at a certain number of standard deviations (generally 2) away from the middle line to incorporate volatility. 

Take a look at the image below –

Bollinger Bands Calculations

The Bollinger Bands uses 2 components – time period and standard deviation to determine SMA and upper and lower bands. 

1. SMA - The simple moving average is calculated by summing up the closing prices of the asset, say a stock and then dividing it by a certain time period. In most standard Bollinger Bands, the SMA is 20 days, i.e., you will add the stock's closing price for over 20 days and divide the sum by 20. 
2. Standard Deviation (SD): To calculate upper and lower bands, we will take standard deviation (SD) into consideration. The SD typically measures how spread out the prices are from the moving average or how the stock’s price differs from its mean value. For instance, if the price deviates away from the mean to a large degree, it can mean the stock is experiencing high volatility. 
3. Upper and Lower Bands – The upper and lower bands, which are your Bollinger Bands, are established by adding and subtracting a designated number of SDs (often 2) from the SMA. As you do this, you generate a lower and upper band, creating a channel encompassing price movement. This channel will expand or contract in response to volatility. 

So, if you are calculating the Bollinger Bands at two standard deviations based on a 20-day simple moving average, then –

• Middle Band = 20-Day SMA
• Upper Band = 20-Day SMA + (20-Day SD *2)
• Lower Band = 20-Day SMA - (20-Day SD *2)

Bollinger Bands Interpretations

Bollinger Bands can be interpreted in many ways, some of which are as follows:

• Support and Resistance Levels: The upper and lower bands often act as dynamic support and resistance levels. In an uptrend, the price tends to hug the upper band, while in a downturn, it gravitates towards the lower band. Breakouts above or below the bands can suggest trend reversals or sometimes continuation.
• Overbought and Oversold Levels: Bollinger Bands can help identify overbought and oversold levels. If the price touches or exceeds the upper band, the asset or stock can be considered overbought, and a pullback may occur. The opposite is true when the price touches the lower band.
• Volatility: When the bands are close together, it may indicate low volatility, often called the ‘Bollinger Squeeze.’ This period of low volatility may be followed by a significant price movement. Conversely, if the bands widen, it may indicate higher volatility or that a trend may be ending.

Prices can also trail along or hug a particular band and then bounce off to another band. For instance, the price may move along the  upper band and then touch back or bounce off the SMA, creating the ‘Bollinger Bounce.’ 

The Bollinger ‘squeeze and bounce’ can help generate entry and exit points along with buy and sell signals. 

And with these, we end the 1st phase of trending indicators. In the next chapter, we will be exploring in depth the MACD, and RSI indicators.