What Is The Average Directional Index (ADX)?
The trend is one of the crucial factors helping investors make their trading decisions and increase potential profits. Not only does it important to understand the direction of the trend but also how strong it is. Here comes the Average Directional Index or ADX for short. It’s a widely used technical analysis indicator allowing traders to analyze if the market is trending and gauge the trend strength. Read on and find out everything you need to know about ADX: features, ways to calculate it, merits and drawbacks, and more.
What Is the Average Directional Index (ADX)?
The Average Directional Index (ADX) is a technical indicator created by Welles Wilder to measure the trend strength. Many traders make use of it to spot the buying/selling signals or periods when it’s better to hold the investment. Although initially it was meant for the commodity market, nowadays it is efficiently used with other types of financial instruments such as stocks, forex, indices, etc.
Monitoring market movements, the ADX indicator may range from 0 to 100. According to Wilder, the values over 25 denote a strong trend while the values under 20 indicate a weak trend, implying that the market fluctuates within the trading range.
ADX is commonly implemented along with other two indicators, the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI), this way being presented by three lines on the chart.
- ADX line helps traders identify the strength of the trend not the direction of it;
- +DI line determines the strength of the upward price movement;
- -DI line shows the strength of the downward price movement.
When it comes to the indicator settings, the timeframe is usually represented by a 14-day period. However, it can be changed depending on the trader’s strategy, style, and type of asset.
The Average Directional Index (ADX) vs. The Aroon Indicator
The ADX and the Aroon indicators have much in common. Both of them keep track of the trend strength. However, they are not the same. In contrast to the ADX, which is formed by three lines on the chart, the Aroon indicator is represented by only two, the Aroon Up and the Aroon Down. What’s more, due to the differences in calculations, the lines of these indicators won’t coincide in the crossover points.
How To Calculate Average Directional Index
To calculate the Average Directional Movement index, follow the steps below:
- First, it’s necessary to find out the values of the Positive and the Negative DMI (Directional Movement Indicator). Calculate the up-move and the down-move:
Up-move = Current high - Yesterday’s high
Down-move = Yesterday’s low - Current low
- If the value of the up-move is more than the value of the down-move and more than 0, then +DM=up-move, else +DM=0.
If the value of the down-move is more than the value of the up-move and more than 0, then -DM=down-move, else -DM=0.
- Use the formula below to calculate Positive and Negative DI.
+DI = 100EMA of +DI / ATR of a particular period (usually 14 days)*
-DI = 100EMA of -DI / ATR of a particular period (usually 14 days)*
EMA stands for Exponential Moving Average.
ATR is short for the Average True Range.
ADX = 100 * EMA of the absolute value of (Positive DI - Negative DI) / (Positive DI + Negative DI)
How To Read ADX
Before getting started with interpreting the three-line chart, let’s find out what the ADX line can tell by itself.
- It’s crucial to underline that the ADX is a non-directional indicator, meaning that it doesn’t gauge the direction of the trend but only its strength. Thus, the ADX value will be going up in either a strong uptrend or downtrend market.
- When the value of the ADX is over 25 the market is trending. Investors are likely to implement trend-based strategies and open long or short trades depending on the direction of the trend.
- When the value of the ADX is below 25 (or 20), the market is described as trendless, meaning that it fluctuates within the levels of support and resistance. This is when traders could use non-trending strategies.
- ADX value near 50 signals an extremely strong trend, while values over 50 are quite rare to happen in any type of market.
- When the ADX line starts moving down it’s a signal of a weakening trend. Note that it doesn’t necessarily indicate the reversal of the trend.
When it comes to reading the ADX together with +DI and -DI, here is what you can figure out.
- If the +DI is above the -DI, and the ADX indicator is over the value of 25, this is a sign of the strong bullish market trend.
- If the +DI is below the -DI, and the ADX is over the value of 25, this is the signal of the strong bearish market trend.
- If the ADX is below the value of 20 while the +DI and -DI are continuously overcrossing each over, this situation indicates a trendless market.
How Is ADX Used In Trading?
The core feature of the Average Directional Index is the ability to identify if the market is trending and determine the strength of this trend. Although the line of the ADX itself can’t define the direction of the price movement, used in combination with +DI/-DI or other technical indicators it could be a seamless tool helping investors decide whether to opt for short or long trades, this way keeping the optimal side in their trading strategies. For example, when the +DI is above the -DI, traders could take advantage of the bullish market and open long positions. Conversely, if the +DI is below the -DI, it’s an opportunity to close the long trade or enter the short position.
Note, that ADX is a lagging indicator, meaning that it doesn’t predict future price movements but only reacts to the already-established market trend.
What Are The Advantages of Using The Average Directional Index?
ADX is a widespread technical indicator for several reasons. Here are some of them.
- ADX is a relatively friendly and easy-to-implement indicator that could improve the trading experience of both beginners and seasoned investors. However, it’s important not to get confused with its direction. Remember that ADX value will be growing regardless of whether the market is experiencing a strong uptrend or a downtrend.
- ADX indicator is best at identifying if the market is ranging or trending. Thus, by using it, traders could define what strategy to use: trend-based or non-trending.
- ADX is a momentum indicator. By analyzing its values and identifying increasing momentum, traders may gain confidence and remain in the trade for a longer period instead of exiting it before the trend finishes, this way reaping potentially higher profits.
What Are The Limitations of Using the Average Directional Index?
Every technical indicator has its merits and drawbacks, simply because they have a certain range of features. Here are the most important limitations of the Average Directional Index.
- Being a lagging indicator, ADX reacts to an already existing trend, it can’t foresee it. Therefore there may also be some gaps between the price movement and the ADX line.
- +DI and -DI may be prone to producing misleading signals, especially when the price volatility is high.
- ADX, like any other indicator, may not be that efficient when implemented alone. Therefore, it’s advised to use it in combination with other technical tools such as RSI, Stochastic oscillator, MACD, and others.
Average Directional Index Indicator Example
Let’s consider an example of using the ADX indicator on the indices market. First of all, let’s pay attention to the ADX line taken separately. When it crosses the value of 25 the trend is considered to be strong, otherwise, if it crosses below the value of 20, the trend is supposed to be weak.
By analyzing the three-line chart, you can notice that the period of the ranging market, characterized by multiple crossovers of +DI and -DI, is followed by the bullish crossover. Taking into account that the ADX line also shows a rise over the threshold of 25, it’s possible to say that the DAX30 index is in a strong uptrend.
Here is an example of a bearish stock market. As it’s possible to see there was a bearish crossover, so the -DI went over the +DI. The ADX indicator passed over the level of 25, moreover, soared to over 50. All these three lines together indicate an extremely strong downtrend in the market.
Average Directional Index Strategies
ADX is an effective technical tool, helping traders recognize strong market trends. By paying attention to its value and direction, investors can make more precise trading decisions, as a result reaping potentially higher benefits. Here are the most common strategies making use of the Average Directional Index.
Divergence is a market situation when the trend continues developing (either upward or downward), but the ADX, instead of following this lead, starts to move in the opposite direction. This doesn’t necessarily mean the reversal in the trend direction, it could also be a sign of consolidation, pullback, correction, or further continuation of the trend.
ADX indicator can be used to find ranges in the market. It’s possible to spot one when the ADX value declines from over 25 to under 25, especially when it keeps floating over 20. In this situation, there is no prevalence of either bullish or bearish trends. However, everything can change in case the balance between buyers and sellers shifts to either side.
Trend Direction and Crossovers
While ADX is a seamless tool to measure the trend strength, +DI and -DI lines used in combination with it help investors identify the direction of the trend. Should the +DI line crossover the -DI line from above while the ADX line surpasses the level of 25, there is a high possibility of a strong uptrend. Thus, traders consider it as a sign to enter long (buying) positions. Otherwise, if the -DI line crosses the +DI line from above while the ADX has the value of 25 and over, it’s likely that the downtrend is here to occur. Thus traders can use their opportunity to open short (selling) trades.
However, it’s crucial to remember that -DI and +DI may produce false signals. Therefore, it’s recommended to use ADX with other technical tools at the same time.
ADX and RSI
Both RSI and ADX are momentum indicators, however, in contrast to the latter one, RSI allows investors to indicate overbought and oversold markets. This way, if the ADX has a value over 25 while the RSI is over 70, the market is likely to be overbought, thus, traders may consider entering the short trade. Conversely, when the ADX is over 25 while the RSI is under 30, the market is likely to be oversold, thus it could be a signal to open long trades.
ADX and MACD
MACD (Moving Average Convergence Divergence) has a similar purpose to the ADX. It’s also a trend-following momentum indicator. This way, if combined, they could provide investors with a more accurate picture of the market. Apart from determining the trend and its direction, MACD can also spot reversals. Thus, it’s possible to use ADX to measure the strength of the reversals identified by MACD. For example, if the MACD goes over 0 while the ADX is above 25 and the +DI passes over the -DI, this situation can be considered a signal to buy.
ADX and Parabolic SAR
Parabolic SAR can be an efficient way to reduce the number of false signals produced by the ADX as well as define more precise entry and exit trade points. On the price chart above it’s possible to see that the +DI crosses over the -DI while the Parabolic SAR confirms the bullish trend with dots at the bottom of the price bar. This can be a chance for traders to open long positions.
The Average Directional Movement Index is a widespread technical analysis indicator used to define if the market is trending and to measure the strength of that trend. Implemented along with +DI and -DI it can identify the direction of the trend as well. ADX doesn’t have a steep learning curve, thus, would fit both beginners and experienced traders.
However, it’s important to remember that like any other technical tool, it comes with particular limitations and may be prone to some false signals. Thus, to make your trading strategy more accurate and potentially more successful it’s better to use ADX together with other tools. Some effective combinations could be ADX and RSI, ADX and MACD, ADX with Parabolic SAR, and others. The ADX confluence with other tools as well as its settings should be worked out by traders relying on their goals, strategies, and style.