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Understanding Stock Options Trading
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"I've always been confused about options trading...
at least now I have a better understanding about it!"
Ben Masters
VIC, Australia
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> Technical Guide >
Average directional index (ADX) indicator |
Average Directional Index (ADX) Indicator
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The Average Directional Index, or the ADX indicator
for short, acts as a guide to confirm the signals
produced by other technical indicators. The Average
Directional Index is an indicator that measures
the strength of a trend. For example, it can measure
whether an uptrend or downtrend is gaining momentum
or slowing down.
The Average Directional Index (ADX) indicator is
a combination of the positive directional indicator
(+DI) and the negative directional indicator (-DI).
The +DI tracks the upward trend of the stock, while
the -DI tracks the downward trend. The ADX indicator
combines the two and produces a unified trend strength
indicator.
The ADX indicator is an oscillating indicator, ranging
from 0 to 100, with 0 indicating flat trading, and
100 indicating either a skyrocketing or plunging
stock. The ADX only indicates the strength of the
trend, and does not indicate its direction.
However, it is unlikely to see ADX indicator values
above 60, since such high values indicate a trend
that usually only appears in long bull runs or long
recessions. Usually, any ADX value above 40 is considered
to be a strong trend, while any ADX value below
20 indicates that the stock is in a trading range.
In the chart below, the +DI is depicted as a thin
green line, and the -DI is depicted as a thin red
line. The ADX indicator is the thick black line.
From the chart, the ADX indicates that from late
February to mid April, the stock was in a strong
trend, in this case an upward trend. For this stock,
the ADX indicator did not go below 20, which indicates
that there wasn't a period where the stock was trading
flat. This is quite accurate, since it can be seen
from the stock price that the first 3 months was
an uptrend and the last 3 months was a downtrend.
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Click
here to view a larger updated version of the chart
at Stockcharts.com
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The Average
Directional Index (ADX) indicator depicts
the strength of a trend, and does
not differentiate between an uptrend or a downtrend.
ADX indicator values above 40 indicate a
strong trend, while ADX values below
20 indicate a sideways trading range.
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As
for signals produced by the Average Directional
Index (ADX) indicator, a move below 40 from above
indicates that the trend is slowing. Since most
option strategies rely on large price movements
in short timeframes, a slowing trend is bad. Therefore
an ADX move below 40 would indicate that it is time
to close our positions.
Conversely, an ADX indicator move above 20 from
below indicates that the sideways trading is over,
and a new trend is developing. This would indicate
that it is time to make a move, either bullish or
bearish.
In the chart above, the ADX indicator produced a
signal in mid April indicating that the trend (in
this case upwards) is fading. In early July, the
ADX indicator briefly touched 20 from above and
immediately turned back up. This indicates that
momentum is picking up and a new trend (in this
case downwards) is forming.
Also, signals can be obtained by looking at where
the positive directional index +DI (green) and negative
directional index -DI (red) lines cross each other.
When the +DI crosses above the -DI from below, it
is a bullish signal, such as in early February.
When the -DI crosses above the +DI from below, it
is bearish, such as in late April.
We again stress that basing your investment decisions
on only one indicator is not recommended. It is
best to use it with one or two additional indicators
of different types in order to confirm signals and
prevent false alarms.
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An ADX move
below 40 from above indicates a trend
slowing down. An ADX move above
20 from below indicates a new trend
forming.
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We
hope you have enjoyed this guide, and the way we
described the concepts of technical analysis. There
are many technical indicators out there. We chose
to cover these 5 indicators in order to give you
a feel of the various types in existance. It is
good practice to take 2 or 3 indicators of different
types, and using signals from all of them to make
decisions.
For more information on technical analysis, you
can check out Stockcharts.com's education
section or at ChartFilter.
And if you are would like to learn
stock options and the various option
strategies available, do visit our Option
Basics Guide if you have not already done so.
If you want to link to this guide, please
click here.
Thank you!
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| All stock options trading
and technical analysis information on this website is for educational
purposes only. While it is believed to be accurate, it should not be considered
solely reliable for use in making actual investment decisions.
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