What is the Average Directional Index (ADX)?
The Average Directional Index (ADX) is a popular technical analysis tool and a widely-used three-line indicator. It helps traders to find out if the market is trending and how strong this trend is.
Often referred to as the trend strength indicator, this ultimate trend indicator enables investors to trade in the direction of a strong trend, reducing the risk and increasing the potential for profit. ADX may be applied to any trading instrument, including stocks, indices, commodities and Forex.
The ADX Indicator commonly includes three separate lines. The ADX is usually accompanied by two other indicators – the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). These lines help traders decide whether to take a long or a short trade or hold back from making a trade at all.
To quantify the trend’s strength, the calculation of the Average Directional Index is based on a moving average of a price range expansion over a certain timeframe. Typically, the indicator is calculated for a 14-day period, although it may be implemented to any — including an hourly or weekly — chart.
Who invented the Average Directional Index?
The Average Directional Index (ADX) was created in 1978 by J. Welles Wilder for analysing commodity price charts but can be perfectly applied to any markets and timeframes.
Born in the 1930s, J Welles Wilder was an engineer turned real estate developer, turned technical analyst.
Best known for his works on technical analysis, Mr Wilder also created the Average True Range and Parabolic SAR indicators.
Why is the Average Directional Index useful to traders?
The major purpose of the Average Directional Index (ADX) indicator is to find out whether a stock, currency pair or commodity is trending in a direction or stuck in a range. Often used as a complement to other technical indicators, the ADX is a strong factor in deciding whether to buy or sell an asset.
The Average Directional Index is a lagging indicator, meaning that a trend must have already established itself before the ADX can generate its signal. It’s often said that the best profits come with the strongest trends. The ADX helps traders to avoid range conditions and find out the strongest trends to ride.
How can a trader anticipate whether a trend will continue, or reverse to eliminate all the profits? This is the situation in which the ADX should be employed.
Technical analysis: how to trade with the Average Directional Index?
One of the most important things to remember about ADX trading is that the indicator moves regardless of the direction of the underlying stock, showing only the strength of the trend. Both strong upward and downward trends increase the Average Directional Index.
Primarily used for defining a trend strength, or momentum, the indicator is calculated according to the Average Directional Index formula.
To calculate the ADX, you should first specify the positive (+) and negative (-) DM or directional movement. The +DM and –DM can be determined by calculating the “up-move” (current high minus the previous high) and the “down-move” (current low minus the previous low).
If the up-move is larger than the down-move and is more than zero, the positive directional movement or (+DM) equals the up-move. Otherwise, it equals zero.
If the down-move is larger than the up-move and is more than zero, the negative directional movement (-DM) equals the down-move. Otherwise, it equals zero.
The Positive Directional indicator (+DI) equals 100 times the EMA (exponential moving average) of +DM divided by the ATR (average true range) for a set number of periods (usually for 14 days). The Negative Directional indicator (-DI) equals 100 times the EMA of –DM divided by the ATR.
The ADX indicator equals 100 times the EMA of the absolute value of (+DI minus –DI) divided by (+DI plus –DI).
The primary momentum indicator, the Average Directional Index ranges between 0 and 100, where high numbers indicate a strong trend and low numbers indicate a weak trend.
ADX below 20: the market is currently not trending
ADX crosses above 20: signifies that a new trend is emerging. Traders may start placing sell or buy orders in the direction of the price movement.
ADX between 20 and 40: When the ADX is growing between 20 and 40 it is considered as a confirmation of an emerging trend. Traders may use this opportunity to buy or short sell in the trend's direction.
ADX above 40: the trend is very strong.
ADX crosses 50: the trend is extremely strong.
ADX crosses 70: a very rare occasion, which is called a “Power Trend.”
How to use ADX
ADX may become a part of your trading strategy, helping you identify entry and exit points and providing analytical insight. As part of a crossover strategy, you may initiate a long position if the +DI crosses above the –DI. Otherwise, when the –DI crosses above the +DI, you can place a short position, or exit the long one.
Beyond the crossover ADX trading strategy, the ADX, + DI and –DI lines can help you conduct market analysis, evaluating the trend from the moment it starts.