Spot and Stick to Trends with ADX and RSI
When one indicator isn't enough to identify a new trend—or manage a trade in an existing one—some traders combine two: the Average Directional Index (ADX) and the Relative Strength Index (RSI).
Here's how this pairing works. The ADX can signal whether a trend is in place and how strong it is, while the RSI can show if the current price is overbought or oversold and whether it may be time to enter a trade or wait.
In a rising trend, for example, the ADX can confirm the existence of an upward trend, and the RSI can show how potentially overbought prices have become. That may potentially help a trader decide whether it may be a good time to enter the trend or wait for a better entry signal. The key objective of pairing these indicators is using overbought and oversold levels to decide whether—or when—to enter a trending stock.
"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 research and strategy at the Schwab Center for Financial Research. However, he added that complementary indicators may offer more than candlesticks or moving averages alone.
Used together, the ADX and RSI can potentially help traders flag divergences between the indicators' peaks and troughs and those of the corresponding security's price. These divergences "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.
What does the ADX measure?
The ADX is a gauge of a trend's strength measured on a scale of zero to 100. A reading between 20 and 40 indicates a trend is in place—up or down—and gathering strength. When the ADX begins to move above 20, it can signal a trend may be forming, and the underlying security's price chart can help identify whether that trend is up or down.
"ADX readings over 40 typically suggest very strong trending territory but could also mean a potential top or bottom is on the horizon," Peterson said.
Readings in the 60 – 100 area indicate an extremely strong trend and are relatively rare. A reading below 20, on the flip side, indicates no meaningful trend is in place, which opens the door for the RSI to add directional guidance. It's important to monitor historical ADX peaks and troughs to help identify where the underlying security may be within the lifespan of its typical trend.
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What does the RSI show?
The RSI is an oscillator 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 generally, the critical signal lines are at 30 and 70. A reading below 30 indicates a security may be oversold, and a reading above 70 indicates the asset may be overbought. In strong bull markets, however, sometimes a move above 80 is considered overbought and a move below 40 is considered oversold. The historical RSI of the stock can help provide guidance by noticing at what levels the stock tends to mean-revert within the trend.
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. "The stronger reversal signals often come when the ADX tops out, suggesting fading momentum, and coincide with an overbought or oversold RSI reading," Peterson said.
What do 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 may be susceptible to a decline. It suggests the price has risen too far, too fast, and may be due for a pullback. It's important to keep in mind that this is not necessarily the same as a bearish condition.
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. Tracking the ADX and RSI together can help traders get a better sense of the overbought and oversold balance.
Combining RSI and ADX: Some guidelines
"Generally, the RSI is subject to the ADX and whether or not it's in trending territory," Peterson said. "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."
In other words, the ADX provides the dominant decision-making criteria—allowing traders to see whether there is a trend or not and how strong it may be. The RSI offers secondary evidence—real-time analysis of whether the security is in overbought or oversold territory. It also provides potential timing signals on when it might be best to enter the trade in the direction of the trend.
At the same time, a turn lower in the ADX may signal a pause in the trend, where price movements in the trend's direction 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 or sell signals on its own. If the ADX continues to fall, the RSI's signals gain more credibility and usefulness in managing an investment.
Tracking the trend
A trend is simply a sustained directional price move, up or down, in a stock, index, or other security. The chart below shows an example of a downtrend that could be nearing a reversal. As the daily chart shows, the downtrend in stock ZYX (candlesticks) started with a bearish engulfing candle (marked A) that persisted for several weeks. This trend was validated by the ADX (red line) increasing from below 20 to just over 40 (B), followed by five days of sideways price consolidation (C).
Source: thinkorswim platform
For illustrative purposes only. Past performance does not guarantee future results.
During this sideways consolidation period, there are a few signals that could suggest the downtrend is ending:
- The RSI (gray line) moved off its lows (cyan line segments) and approached the 70 level a couple of times, known as a positive divergence.
- The RSI also moved from an oversold reading below 30 to back above 30.
- The ADX shifted from moving higher to sideways and is potentially in the process of forming a peak (marked D).
A trader who was capitalizing on the downtrend through a short equity position or bearish options position might consider exiting the trade. The RSI's move from below 30 to above this level can be interpreted as a near-term bullish signal, but there may not be enough evidence yet to support a long position. It's also possible the stock is consolidating before resuming the downtrend.
Putting the ADX/RSI to work
The ADX and the RSI are available among dozens of studies on the thinkorswim® platform. Here's how to locate the ADX:
- Select the Charts tab (red rectangle) and enter a stock symbol (blue rectangle).
- Select the beaker symbol (yellow square).
- In the Edit Studies and Strategies window, select ADX (green rectangle), then Add selected (purple rectangle), and finally OK (white square).
Source: thinkorswim platform
For illustrative purposes only. Past performance does not guarantee future results.
The following chart shows how to identify historical trends in stock ZYX (candlesticks) by using the ADX (red line) and determining whether it may be in overbought or oversold territory with the RSI (yellow line).
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.
The RSI (bottom panel) shows momentum signals that eventually confirm the uptrend when ZYX 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.
Rectangle 3 shows a bearish divergence: The stock tests prior highs while the ADX starts to roll lower, suggesting the uptrend is weakening. A downtrend eventually followed.
Source: thinkorswim platform
For illustrative purposes only. Past performance does not guarantee future results.
Together, these signals illustrate how a trend-following approach could play out in practice. From the left, there appear to be several 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 overbought levels, which is less important because the ADX shows that the trend higher is still 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 indications from the ADX and RSI that the trend higher could be ending. Depending on the trader's underlying strategy and risk tolerance, they could exit an existing long position, tighten a trailing stop order, or explore a bearish strategy consistent with their risk profile.
The stock price in this example eventually begins to decline, and the ADX hits a low point (rectangle 4) before beginning to rise again (yellow arrows), suggesting a new trend may be forming—this time to the downside. The upward yellow arrow on the ADX signals the downtrend is gaining strength, mirrored by the downward arrow above the price.
The RSI 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 might remain bearish.
Bottom line: Two indicators, one clearer picture
No single indicator can tell a trader everything, and the ADX and RSI are no exception. Used together, however, the ADX can help quantify the existence and strength of a trend while the RSI helps gauge momentum. The pair can provide a more complete read on price action than either provides alone and give traders more insight into timing trade entries and exits.
As with any technical tool, ADX and RSI are most effective inside a trading plan that aligns with a trader's objectives, time horizon, and risk tolerance. Consider using the paperMoney® feature in thinkorswim before putting real capital to work.
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This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The securities, investment products and investment strategies mentioned are not suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment or trading decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
For illustrative purposes only. Individual situations will vary. Not intended to be reflective of results you can expect to achieve.
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Past performance is no guarantee of future results.
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