ADX indicator explained: strategies, signals & trading tips

You’ve spotted a trend in your favourite asset. The direction tells you whether to go long or short. Should you consider opening a position? What should the position size be (or how much capital to deploy)? The answers to these will depend on the strength of the trend as this influences the risk-reward ratio. Here’s where the average directional index (ADX) becomes crucial for your trading strategy. It is an indicator that helps you gauge the intensity of the trend.

What is the average directional index (ADX)?

The ADX is a technical analysis indicator that quantifies the strength of a trend. It doesn't indicate the direction of the trend, but rather its vigour. This helps you determine whether your chosen financial asset is likely to make steep moves or merely move sideways.

The ADX was developed by Welles Wilder, a renowned technical analyst who is better known for developing the more frequently used relative strength index (RSI). In fact, Wilder also developed the parabolic SAR.

Traders use it to gain more confidence in their trend-following strategies and to avoid getting their capital stuck in weak or non-trending markets.

How does the ADX work?

To understand what the ADX indicator is, let’s look at how it works. It is typically displayed as a single line below your chart area. This line ranges from 0 to 100.

The ADX is derived from 2 other directional movement indicators:

• the positive directional indicator (+DI), measures the strength of upward price movement.
• the negative directional indicator (-DI), which measures the strength of downward price movement.

The ADX line represents the average of the difference between +DI and -DI, smoothed over a specific period, the most common of which is 14 periods.

Here's how to interpret the ADX values:

• 0-20: indicates a weak or non-existent trend.
• 20-25: suggests an emerging trend. A move above 20 often signals the start of a trend.
• 25-50: represents a strong trend.
• 50-75: denotes a very strong trend.
• 75-100: points to an extremely strong trend.

ADX indicator explained: a rising ADX means that the trend strength is increasing, regardless of whether the trend is upward or downward. A falling ADX, on the other hand, shows that the trend is losing strength or the market is entering a range-bound condition. The ADX acts as both a trend confirmation tool and a filter for range-bound markets. When the ADX is high and rising, it indicates a strong trend. When it's low and falling, it suggests the market is choppy or consolidating, potentially limiting the effectiveness of trend-following strategies. Bear in mind, that outcomes may vary, and past performance doesn’t guarantee future results.

How to calculate the ADX

If you’re using MT4 or MT5, the ADX is calculated automatically. You can simply drag and drop the indicator in the chart area. Even then, understanding the indicator’s underlying mechanics can give you deeper insight into its behaviour.

The calculation involves several steps:

True range (TR): take the largest of the following:

• current high minus current low
• current high minus previous close (absolute value)
• current low minus previous close (absolute value)

Directional movement (DM):

• +DM = current high minus previous high (only if positive and greater than previous low minus current low)
• -DM = previous low minus current low (only if positive and greater than current high minus previous high)

If these conditions are not met, +DM and -DM are taken as zero.

Smoothed +DM, -DM, and TR: these values calculated above are smoothed over a period, usually 14 periods, to create the average true range (ATR) and average directional movement (+DMI and -DMI)

Directional movement index (DX): take the absolute difference between +DMI and -DMI, then divide this by their sum and multiply by 100.

Average directional index (ADX): this is a smoothed average of the DX over the chosen period, which we assume is 14 periods. The first ADX value is a simple average of the first 14 DX values. Subsequent ADX values are calculated using a smoothing formula -

Since the mathematical calculation can seem complex, most traders simply use the indicator provided by their trading software. The focus should be on interpreting its signals effectively rather than manually calculating each value.

How to read and use ADX signals

Reading ADX signals involves understanding what different values mean in terms of trend strength and identifying potential trading opportunities.

Trend strength interpretation

• ADX below 20-25 indicates a weak or ranging market. Traders avoid trend-following strategies here.
• ADX rising above 25 can represent an emerging or strengthening trend. Some traders use ADX values above 25 to support trend-following strategies
• ADX above 40 signifies a strong, well-established trend. This may present attractive opportunities for trend traders.
• ADX falling from high levels suggests the trend is losing momentum and may be nearing exhaustion or a reversal.

Entry/exit triggers

While ADX is not typically used for precise entry and exit points, it plays a crucial role in confirming them. If you’re using another indicator to identify a trend and the best entry and exit prices, you may use the ADX as confirmation before opening a position. For instance, a strong ADX (above 25) can confirm a breakout from a consolidation pattern. This gives you higher confidence for an entry. When the ADX starts to fall from high levels, it might signal an opportune time to take profit or tighten your stop-loss, as the trend is losing steam.

Identifying trend strength and momentum shifts

The ADX helps distinguish between directional moves and sideways price action. A rising ADX signifies increasing momentum, while a falling ADX suggests a loss in momentum. This allows you to adapt your trading strategy.

• When the ADX is strong and rising, think about focusing on trend-following strategies.
• When the indicator is weak and declining, consider range-bound strategies or wait on the sidelines till a trend is established.

ADX crossovers and breakouts

Although not as commonly used for direct signals as +DI and -DI crossovers, the ADX itself can provide valuable context for breakouts. A breakout that occurs with a rising ADX above 25 is generally more reliable than one that occurs with a low or falling ADX, as it indicates genuine underlying strength in the new trend.

Top ADX trading strategies

The ADX indicator is rarely used in isolation. Its usefulness emerges when combined with other indicators or specific trading setups. Here are some popular ADX trading strategies:

Combining ADX with other indicators

The effectiveness of ADX increases significantly when it is combined with other technical indicators. With this, you can spot trading signals that are more reliable. Such an approach is called ‘confluence trading’.

Confluence trading example

Imagine a scenario where the price of an asset breaks out of a consolidation pattern. The ADX rises above 25, confirming the strength of the breakout. The MACD shows a bullish crossover, indicating upward momentum. And, the RSI is not in overbought territory, suggesting room for further price appreciation.

This confluence of signals provides a much stronger trading opportunity. It’s best to avoid relying on any single indicator.

Advantages and disadvantages of using ADX

Understanding the strengths and weaknesses of the ADX indicator helps you know what to leverage and what pitfalls to avoid.

Advantages

Filters weak trends: the ADX is a measure of strength in the trend. By doing this, it helps you filter out weak and non-trending markets, which you’d perhaps be better off avoiding.

Works across timeframes: it is a versatile indicator and can be used with any timeframe, from minute charts for day trading to weekly or monthly charts for long-term investing. This makes it suitable for various trading styles.

Effective with other tools: ADX is designed to be used seamlessly with other indicators. Its main aim is to confirm signals generated by other indicators or chart patterns, increasing the reliability of a trading strategy.

Disadvantages

Lags in early trend stages: the ADX is a lagging indicator. It is based on historical price data and confirms a trend only after it has already begun. This means traders using ADX might miss the very early stages of a new trend.

Can be misleading in choppy markets: in highly volatile, choppy, or sideways markets where prices oscillate rapidly without a clear direction, the ADX can sometimes give misleading signals or fluctuate around the 20-25 threshold, making it difficult to ascertain trend strength.

Not ideal for entries without confirmation: the ADX itself does not provide entry or exit signals. It tells you how strong a trend is, but not where to buy or sell. Relying solely on ADX for trade entries can lead to poor results. It is necessary to combine ADX with other indicators or price action analysis.

Real-world examples of using the ADX

ADX in trend vs range conditions

The ADX behaves differently in different phases of the market and is crucial for adapting trading strategies accordingly.

Trending conditions: when a market is on a strong uptrend or downtrend, ADX will typically be above 25 and rising. The higher the ADX value, the stronger the trend. In a strong uptrend, +DI will be significantly above -DI, while in a strong downtrend, -DI will be significantly above +DI. In both scenarios, the ADX can still confirm the trend's strength. This helps traders to buy on pullbacks in an uptrend and sell on spikes in a downtrend.

Range conditions: when a market is range-bound or consolidating, the ADX will typically be below 20-25 and often flat or declining. This indicates a lack of directional strength.

In these conditions, +DI and -DI will often be close to each other, reflecting the indecision in the market. Traders would normally put their capital in other assets or buy at support and sell at resistance with the aim of making small profits.

ADX value thresholds to avoid overtrading

ADX below 20: it signals a non-trending market. It may be best to avoid opening new trend-following positions and either stand aside or switch to range-bound strategies. Entering in such conditions often results in false breakouts and unprofitable trades.

ADX falling from high levels: a high ADX indicates a strong trend, but if it starts to fall consistently, it signals that the trend is losing momentum. This doesn't necessarily indicate a reversal. Rather it is a warning to traders wishing to chase the trend. It suggests taking partial profits or tightening stops.

Adaptive strategies for changing volatility

The ADX's ability to measure trend strength indirectly helps you adapt to changing market volatility.

High volatility, strong trend (ADX high and rising): pro traders focus on capturing larger moves, potentially using wider stop-losses or trailing stops as the trend has strength.

Low volatility, ranging (ADX low and flat): experienced traders tend to reduce position sizes, shorten profit targets, or avoid trading altogether. Strategies based on breakouts from tight ranges can be considered once the ADX starts to rise.

Trend exhaustion (ADX falling from high levels): traders brace for potential reversals or deep corrections. This is a time for caution and risk management.

Tips to trade more effectively with ADX

Here are some tips to maximise the effectiveness of the ADX and minimise false signals:

Best settings for swing/day trading

The default and most commonly used setting for ADX is 14 periods. This is a balanced setting that provides a good blend of responsiveness and smoothing. It's generally suitable for swing trading and longer-term analysis.

Shorter periods, like 2, make the ADX more sensitive to price changes, producing quicker signals. They are often preferred by day traders and scalpers who need to react quickly to intraday trends. The downside is that this can generate many more false signals.

Longer periods, like 20 or 25, make the ADX less sensitive and smoother, reducing whipsaws. They are more suited for longer-term trend analysis and position trading, but they will lag more significantly.

The best setting depends on your trading style, the asset you're trading, and the timeframe you're using. Practise on a demo account to know which settings suit you best.

How to reduce false signals

As a lagging indicator, ADX can sometimes give late or false signals, especially in choppy markets. Always look for volume to confirm ADX signals. In a strong uptrend confirmed by ADX, rising volume on upward price action and declining volume on pullbacks add conviction.

Remember: a breakout with a rising ADX but low volume might be a false signal.

Price action analysis

Candlestick patterns: combine ADX with strong candlestick patterns, like engulfing patterns, hammers, and shooting stars, for entry/exit confirmation. For instance, a bullish engulfing pattern in an uptrend with a rising ADX provides a high-probability entry.

Support and resistance: use ADX to confirm breakouts from established support or resistance levels. A breakout with a rising ADX above 25 is more reliable.

Trendlines and chart patterns: ADX can confirm the strength of trends identified by trendlines or the validity of breakouts from chart patterns like triangles or flags.

Common myths about ADX

Myth 1: A high ADX suggests an uptrend

Reality: ADX measures trend strength, not trend direction. You need +DI and -DI (or other indicators) to determine if it's an uptrend or downtrend.

Myth 2: A falling ADX means a reversal

Reality: a falling ADX indicates the trend is losing momentum. This may not result in a reversal. Instead, it may lead to consolidation or a correction before the original trend resumes.

Myth 3: ADX provides entry/exit signals

Reality: ADX is merely a confirmation tool. It is not a signal generator for entries. Relying solely on ADX for entries often leads to poor trade timing. It should be used along with other indicators or price action.

Myth 4: A low ADX suggests the absence of trading opportunities

Reality: a low ADX indicates a ranging market.

Summary and key takeaways

The average directional index (ADX) is a powerful tool used for confirming trends highlighted by other indicators. It quantifies the strength of a trend, which cannot be captured by directional indicators.

Avoid relying solely on ADX, as it:

• does not provide entry and exit signals. Always combine it with other indicators or price action for entry and exit points.
• won't tell you if the market is going up or down.
• can be misleading or generate whipsaws in sideways or highly volatile.
• might confirm a trend only after it has already moved significantly.

You can improve your trading decisions by understanding the nuances of ADX and integrating it into a broader trading plan that uses other indicators and has robust risk management.

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