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

The average directional index, or ADX, is a popular technical analysis tool. Learn more about it in our educational guide.

The average directional index (ADX) is a technical analysis tool that measures the strength of trends. It is a standard analytical tool provided by most trading platforms.

To quantify a trend’s strength, the calculation of the ADX is based on the moving average (MA) of a price range expansion over a certain timeframe. Typically, this is a 14-day period, although it may be implemented into any chart.

The index was developed by J. Welles Wilder, Jr. with commodities in mind but can equally be applied to foreign exchange (forex), shares, futures, indices and exchange-traded funds (ETFs).

The key purpose of the average directional index indicator is to find out whether an asset is trending in a direction or stuck in a range. It is often used as a complement to other technical indicators.

The ADX is a lagging indicator, meaning that a trend must already be established before the index can generate its 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 +DI line indicates the strength of positive movement and is calculated by taking away the previous day’s high from the current day’s high.

The -DI line indicates the strength of negative movement and is calculated by taking away the previous day’s low from the current day’s low.

The ADX line indicates the strength of movement over the period.  

The positive directional indicator is 100 times the exponential moving average (EMA) of +DI divided by the average true range (ATR) for a set number of periods (typically 14 days). The -DI equals 100 times the EMA of -DI 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).

So, the average directional index formula is:

One of the most important things to remember about ADX trading is that the indicator moves regardless of the direction of the underlying asset, showing only the strength of the trend. Both strong upward and downward trends increase the average directional index. 

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 is emerging.

• ADX between 20 and 40: This is considered as a confirmation of an emerging trend.

• ADX above 40: The trend is very strong.

• ADX crosses 50: the trend is extremely strong.

• ADX crosses 70: A very rare occasion, called a “power trend”.

Advantages

• The average directional index may help traders identify the strength of a trend and the potential for a trend reversal.

• Traders could utilise the ADX to help them determine entry or exit points for a trade.

• The ADX could be used to identify potential overbought or oversold levels in the market.

Disadvantages

• The average directional index could generate false signals, which could potentially lead traders to making a loss.

• The ADX lags the price action, so it may be too late for the trader to take action on a potential trade.

• The ADX provides limited information about the market and does not provide any insight into how long is likely to last.

The average directional index (ADX) may be a useful tool for traders, as it can provide an indication of how strong a trend may be and how intense its momentum may be, therefore allowing traders to potentially make better informed trading decisions. The ADX could also be used alongside other technical analysis tools, in order for traders to get a clearer picture of a trend.

However, it’s important to remember that even when utilising an ADX trading strategy there is always a risk of loss. Therefore, having a solid risk management strategy in place is crucial to protect your capital. Traders should do their own research before making any trading decision, taking into account their expertise in the market, attitude towards risk and the spread of the portfolio, among other factors. Additionally, they should never trade with money they can’t afford to lose.