Average directional index (ADX) trading strategy: an educational guide

The average directional index, or ADX, is a widely used technical analysis indicator. In this guide, we explain what the ADX is and how you can use it in your CFD trading.

The average directional index (ADX) is a technical indicator designed to measure the strength of a market trend. It’s included as a standard tool on most trading platforms.

The ADX quantifies trend strength by calculating the moving average of a price range expansion over a specific timeframe – typically 14 days – though you can apply it to any chart.

Originally developed by J. Welles Wilder, Jr. for commodities trading, the ADX can also be used to analyse trends in forex, shares, commodities, indices, cryptocurrencies, futures, and exchange-traded funds (ETFs).

The key purpose of the average directional index indicator is to learn whether an asset is trending in a direction or stuck in a range. You can use the ADX alongside other technical indicators to measure trend strength.

The ADX is a lagging indicator, meaning that a trend must already be established before it can generate a signal.

*Past performance is not a reliable indicator of future results.

An ADX chart will usually feature three lines, the ADX, the positive directional indicator (+DI) and the negative directional indicator (-DI).

• The ADX line – indicates the strength of the trend.
• The +DI line – measures the strength of upwards price movement, calculated by subtracting the previous day’s high from today’s high.
• The -DI line – measures the strength of downward price movement, calculated by subtracting the previous day’s low from today’s low.

To calculate the +DI and −DI, you:

• Find the difference in highs (+DI) or lows (−DI) between today and the previous day.

Take 100 times the exponential moving average (EMA) of these values and divide by the average true range (ATR) for the chosen period (often 14 days).

The ADX indicator equals 100 times the EMA of the absolute value of (+DI minus -DI) divided by (+DI plus -DI).

So, the average directional index formula is:

When using the average directional index, keep in mind that it measures only the strength of a trend, not its direction. The ADX indicator rises in both strong upward and downward trends – what matters is the intensity of the movement, not whether the market is rising or falling.

The ADX indicator is measured on a scale from 0 to 100. The higher the ADX reading, the greater the strength of a trend.

• ADX below 20: The market is currently not trending
• ADX crosses above 20: A new trend may be emerging.
• ADX between 20 and 40: This is considered as a confirmation of an emerging trend.
• ADX above 40: Indicates a very strong trend.
• ADX crosses 50: the trend is extremely strong.
• ADX crosses 70: a rare occurrence, considered a 'power trend'.

Advantages

• The ADX may help you assess the strength of a trend and identify potential areas for a reversal.
• You can use the ADX as a filter to inform your potential entry and exit points.
• In some cases, the ADX can indicate when markets are potentially overbought or oversold, though this is not its primary function.

Disadvantages

• The ADX can produce false signals, especially in choppy or range-bound markets, which may result in losses.
• As a lagging indicator, the ADX may signal trends after they have already begun, making it harder to react promptly.
• The ADX does not provide insight into how long a trend might last or indicate the direction of the trend – only its strength.

The average directional index (ADX) can be a valuable tool for assessing the strength of a market trend. By measuring trend intensity, the ADX may help you make more informed trading decisions, especially when combined with other technical analysis indicators to build a clearer view of market conditions.

Remember, no indicator is foolproof – past performance isn’t a reliable indicator of future results. Even with an ADX-based strategy, there is always a risk of loss. It’s essential to have a robust risk management plan and trading strategy in place and to consider your own experience, risk tolerance, and portfolio diversification before trading. Always do your own research and never trade with funds you cannot afford to lose.

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