Spot and Stick to Trends with ADX and RSI (2024)

If one indicator isn't working well enough to help you spot potential new trends or manage your position in a current trend, trycombining two: the Average Directional Index(ADX) and the Relative Strength Index(RSI).

Here's how this couple works. The ADX can indicate whether a trend is in place and how strong that trend may be. The RSI can show whether the current price may be overbought or oversold and whether it's time to enter the trend or wait.

In a rising trend, for example, the ADX can confirm the existence of an upward trend, and the RSI can tell you its degree of being overbought. That can help you decide whether it's a good time to enter the trend or to wait for a better one.

"There are no set rules on how to apply technical analysis to one's trading strategy; that is a subjective exercise," according to Nathan Peterson, director of derivatives analysis at the Schwab Center for Financial Research. However, he added that complementary indicators can potentially offer more than candlesticks or moving averages alone.

Using indicators like the ADX and RSI in specific cases"can offer insight into the strength of the underlying security's trend, how long it's been trending, and whether there are any signs the trend may be shifting," Peterson said. They allow traders to look for"divergences in the peaks or troughs of the indicator and the corresponding price."

Beyond helping you understand if a trend is in place—and how strong that trend might be—it's also important to keep in mind your overall position direction, your entry point, your position size, your stop order, and your take-profit target. Also note that if a trend is in place, a trailing stop order can be a potentially effective way to stay with the trend until it changes.

Peterson added that an "ADX reading of 40 or higher could be an indication that a trend is long in the tooth and a potential top or bottom may be on the horizon."

The ability to determine when to enter a trending stock by examining when it might be overbought or oversold is the key benefit of pairing these indicators.

The RSI is anoscillator that measures the strength of a price movement on a shorter-term basis—days or weeks. It's also based on a scale of zero to 100. But the critical signal lines are at 30 and 70, where a reading below 30 indicates a security may be oversold and a reading above 70 indicates the asset may be overbought.

Remember, in a trending market—ADX above 20—overbought and oversold conditions are common occurrences and do not always provide a reliable trade signal on their own. For example, a sideways consolidation, the passage of time, or a small countertrend movement could allow the RSI to unwind and exit overbought or oversold territory, even with little overall price movement in the underlying asset because it's still in a trend. Monitor the RSI for moves into overbought or oversold ranges because they may signal a top in the ADX in coming sessions. Peterson said that a stronger reversal signal is given when the ADX tops out, meaning a trend is losing momentum and the RSI is overbought or oversold.

You'll find the ADX and the RSI among dozens of studies on the thinkorswim^® platform. Here's how to locate the ADX:

• Select the Chartstab (red rectangle) and enter a stock symbol (blue recentangle).
• Select the beaker symbol (yellow square).
• In the Edit Studies and Strategies window, select ADX (green rectangle), then Add selected(purple rectangle), andfinally OK (white square).

While the ADX and the RSI can both be used independently, using the pair in tandem can provide a basis for planning a trade and monitoring it once it's made:

• The ADX provides the dominant decision-making criteria—allowing you to see whether there is a trend or not and how strong it may be.
• The RSI provides the secondary evidence—real-time analysis of whether that investment is in overbought or oversold territory. It also provides potential timing signals on when it's best to enter the trade in the direction of the trend.

For example, if the RSI is in overbought territory (above 70), and the ADX is indicating the trend higher is strengthening, the ADX should take precedence over the RSI because the primary strategy is to follow the trend—when there is one.

What is a trend?

Consider the following "if/then" guidelines on using the ADX and the RSI in tandem. The rules are in line with the price chart shown above that depicts the relationship between these two indicators.

• If the ADX is above 20 and rising, it indicates a trend is in place and strengthening. Then the RSI can be used primarily to monitor moves into overbought or oversold territory, possibly signaling the end of the trend.
• If the ADX is in strong trend territory,30 to 40, then consider holding your trend position, but be aware that as ADX approaches 40, it's reaching extreme levels where a trend could stall or even reverse. Otherwise, an ADX in the 20 to 40 range indicates a strong trending state. Peterson saidto keep an eye on the RSI because it may enter oversold or overbought territory, potentially suggesting the trend may see a pause and consolidation. That will likely be confirmed by the ADX topping out and declining, according to Peterson.
• If the ADX is below 20, meaning no trend is in place, then the market is likely moving sideways in a consolidation range. Peterson noted there's a difference between a "trending market" and a "trading market," where the RSI can provide meaningful buy and sell signals of its own. For instance, in the absence of a trend (ADX is less than 20), look to see if the RSI shows an investment has entered overbought (RSI is greater than 70) or oversold (RSI is less than 30) territory. Some traders might consider those rallies and dips as opportunities to sell or buy.

"Generally, the RSI is subject to the ADX and whether or not it's in trending territory,” Peterson said. "So, it's best to defer to the ADX first, and what it says about the existence and strength of a trend. If the trend stalls, the ADX will register a peak and begin to move lower, potentially signaling a consolidation or reversal in the primary trend."

At the same time, a turn lower in the ADX may signal a pause in the trend, where price movements in the direction of the trend become smaller but still follow the trend's main direction. In such a situation, the RSI reading becomes more important and may produce viable buy and sell signals on its own. If the ADX continues to fall, the RSI's signals gain more credibility and usefulness to manage your investment.

What does overbought and oversold really mean?

Overbought is a technical condition that occurs when the price of a stock or other asset is considered too high and susceptible to a decline. It's important to keep in mind that this is not necessarily the same as a bearish condition. It merely implies that the price has risen too far and too fast and might be due for a pullback. The reverse principle applies to an oversold condition, which implies prices have fallen too far, too fast and may be due for a rebound. Similarly, a stock that appears oversold isn't necessarily in a bullish position. Getting a better sense of the overbought and oversold balance can help you place trades more reliably—and that's what tracking the ADX and RSI together can tell you.

Overbought is a technical condition that occurs when the price of a stock or other asset is considered too high and susceptible to a decline. It's important to keep in mind that this is not necessarily the same as a bearish condition. It merely implies that the price has risen too far and too fast and might be due for a pullback. The reverse principle applies to an oversold condition, which implies prices have fallen too far, too fast and may be due for a rebound. Similarly, a stock that appears oversold isn't necessarily in a bullish position. Getting a better sense of the overbought and oversold balance can help you place trades more reliably—and that's what tracking the ADX and RSI together can tell you.

The following chart shows how to identify a trend with the ADX (red line) and determine whether it may be in overbought or oversold territory with the RSI (yellow line). In this example, we measure stock XYZ (candlesticks) to check to see if it's in a trend and how to evaluate the RSI readings along the way.

The first observation is that the ADX is reading above 20 at two different points (rectangles 1 and 4), indicating the formation of two trends—the first up, the second down. Remember, the ADX will rise if a trend is forming,regardless of its direction up or down. Peterson indicated that it's "time to seek confirmation from other indicators, such as an oscillator, to look for negative or positive divergences or any potential candlestick reversal patterns," because they may offer additional evidence that a directional trend could be coming to an end.

Now take a look at the RSI (bottom panel). It's displaying momentum signals that eventually confirm the trend higher when XYZ actually enters overbought territory (rectangle 2). The RSI also shows a bearish divergence as new highs in the stock are made, while the RSI barely matched its prior high.

Notably, rectangle 3 shows a topping pattern (bearish divergence) for the ADX, suggesting potential for a switch to a downtrend—which eventually occurred. The bearish ADX divergence is seen in rectangle 3, where price tests prior highs, but the ADX does not test higher and actually starts to move lower, suggesting the price trend higher is now weakening and possibly reversing.

The chart illustrates how a particular trend strategy could work. From the left, there appear to be a number of trade-worthy trend signals. Rectangle 1 is where the ADX crosses into the trending zone above 20. Because the price direction is higher, it shows an uptrend has formed where long positions could be considered. Rectangle 2 shows the RSI reaching into overbought levels, less important because the ADX shows that the trend higher is in place and gaining strength. By rectangle 3, the ADX shows signs of topping out, potentially signaling a pause or shift in the trend—also a potential exit point for any long position.

At this point, a trader might consider several decisions based on the indication from the ADX and RSI that the trend higher could be ending. They might:

• Exit a long position completely or partially
• Go short
• Tighten up on a trailing stop order
• Raise a stop order level closer to the market level

After rectangle 4, the price of the stock begins to decline, causing the ADX to bottom out and begin rising again (yellow arrows), reflecting that a new trend is likely forming, this time to the downside. At this point, a short position could be considered. The rising yellow arrow on the ADX signals the trend lower is gaining strength, mirrored by the downward-sloping arrow above the price.

The RSI briefly dips into oversold territory below 30 on a sharp downside price move, only to bounce back relatively quickly. But with the ADX still rising, indicating the downtrend is strengthening, traders could stay with the short position. Of course, the shift in trend or position direction would require a new stop order placement above the market or adding a trailing stop to maximize this trend-following trade.