If you want to add a useful trend technical indicator to your trades, average directional index (ADX) is a great place to start. This article explains how to use the ADX to improve your trading strategies.
We'll cover the basics of what the ADX is, how to calculate it, how to interpret its signals and ways to combine it with other indicators. By the end of this article, you should have a solid understanding of how to incorporate the ADX into your trading plan.
What Is the Average Directional Index?
The average directional index (ADX) is a trend strength indicator that measures the degree of market momentum in price or exchange rate movements observed over a specified period. Because the ADX uses historical prices, it is considered a lagging indicator.
Developed by J. Welles Wilder Jr., the ADX is made up of three components: the positive directional indicator (+DI), the negative directional indicator (-DI) and the average directional movement rating (ADXR). These three components help traders using the ADX identify the overall strength of market trends as well as its prevailing direction.
Calculation of Average Directional Index
The calculation for the ADX is typically done by taking the exponential moving average (EMA) of (+DI minus -DI) divided by (+DI plus -DI) multiplied by 100. The (+DI) and (-DI) represent the strength of buying and selling pressure, respectively. The ADX line shows the overall trend momentum, while the +DI and -DI lines reveal the direction of the trend.
To calculate the ADX, you need to first compute the +DI and -DI lines. These lines are used to measure the strength of the uptrend and downtrend, respectively. Here's how to calculate them:
1. Calculate the true range (TR) for each period, which is defined as the greatest of the following:
- The current high minus the current low
- The absolute value of the current high minus the previous close
- The absolute value of the current low minus the previous close
2. Calculate the average true range (ATR) for N periods using the following formula:
- ATR = ((Prior ATR x (N-1)) + Current TR) / N
3. Calculate the +DI and -DI lines using the following formulas:
- +DI Line: (Current High - Prior High) / ATR
If the result is greater than 0, use the value; otherwise, use 0.
- -DI Line: (Prior Low - Current Low) / ATR
If the result is greater than 0, use the value; otherwise, use 0.
4. Smooth the +DI and -DI lines using a moving average. A common choice is the exponential moving average (EMA) over 14 periods. Denote the smoothed values as SM +DI and SM -DI.
5. Calculate the difference directional index (DX) using the following formula:
- DX = absolute value of (SM +DI - SM -DI) / (SM +DI + SM -DI)
6. Smooth the DX over N periods to obtain the ADX line. Again, a common choice is taking the EMA over 14 periods.
Several alternative methods for calculating the ADX exist, such as using the Wilder smoothing method, using a different number of time periods or using the simple moving average (SMA) instead of the EMA. Still, the EMA is generally preferred because it places more weight on recent periods, allowing the ADX to react faster to changing market conditions.
Reading the ADX Indicator
The ADX indicator is ideal for trend trading applications. It fluctuates between 0 and 100 with higher values indicating stronger trends. A value above 25 typically indicates a strong trend, while a value below 20 suggests a weak trend is present in the market.
The ADX line of the ADX indicator shows the strength of the trend, regardless of its direction. Therefore, traders can use the ADX line to identify markets with sufficiently interesting trends to trade and avoid ranging markets.
Furthermore, by looking at the +DI and -DI lines, you can determine the direction of the trend. If the +DI line is above the -DI line, it suggests an uptrend, while if the -DI line is above the +DI line, it indicates that a downtrend prevails. Also, when these lines cross the ADX line, they can provide useful signals for trade entries or exits in alignment with prevailing market trends.
How to Use ADX in Trading
Traders can use the ADX indicator in several ways, such as identifying trend strength, determining trade entry and exit points and validating overbought or oversold levels.
To create trading signals using the ADX indicator, you can use crossovers of the +DI and -DI lines in conjunction with the ADX line. Specifically, if the +DI line crosses over the -DI line and the ADX line is greater than 20, or preferably above 25, it may indicate a buying opportunity. Conversely, if the -DI line crosses above the +DI line, and the ADX is greater than 20 or 25, it could suggest a possible short-selling opportunity.
Common additional applications of the ADX indicator in a trading plan could include:
- Determining market conditions: High ADX values indicate trending markets, while low ADX values point to ranging markets.
- Identifying trend strength: The ADX is commonly used to identify trend strength with higher values indicating a stronger trend.
- Confirming overdone markets: For breakout trading, the ADX can be used in conjunction with a momentum oscillator like the relative strength index (RSI) to validate overbought or oversold markets.
- Filtering trades: You can use the ADX to provide a signal to enter trend-following trades when the indicator is above a certain threshold, such as 25, which signals a strong trend is present.
- Setting stop-loss and take-profit levels: When holding positions, you can place your stop losses beyond recent market swing highs or lows and adjust your take-profit targets based on the strength of the prevailing trend as suggested by the ADX.
Combining ADX with Other Indicators
While the ADX is a powerful tool on its own to include in your trading strategies, its effectiveness can be further enhanced by combining it with other technical indicators to create more robust trading strategies.
Popular indicators to use with the ADX include moving averages, the relative strength index, Bollinger Bands and the moving average convergence divergence (MACD) indicator. Examples of each of these combinations appear below.
Combining the ADX with RSI
Combining the ADX with the RSI can help traders identify overbought or oversold conditions in a strong trend that suggests the market is ripe for a correction or even a reversal. To illustrate this popular usage, if the ADX is above 25 and the RSI is above 70, it may indicate an overbought condition in an uptrend that can prompt a downside reversal. Conversely, if the ADX is above 25 and the RSI is below 30, it may indicate an oversold condition in a downtrend that can lead to an upside market move.
As an example of combining the ADX with the RSI, a swing trader could look for situations to sell when the ADX is above 25 to indicate a strong trend exists but the RSI is reading in overbought territory at 72 since those overextended conditions could indicate a potential correction lower or even a trend reversal to the downside.
Combining ADX with Bollinger Bands
Traders can also use the ADX in conjunction with Bollinger Bands to identify breakouts and trend reversals. For example, when the ADX is above 25 and the price or exchange rate breaks out of its upper Bollinger Band, it may indicate a strong uptrend worth following by going long. Conversely, if the ADX is above 25 and the market breaks out below the lower Bollinger Band, it may indicate a strong downtrend that would warrant taking a short position.
Combining ADX with MACD
The ADX can also be used with the MACD indicator to identify trend strength and momentum. For instance, when the MACD histogram is above the zero line and the ADX is above 25, it may indicate a strong uptrend is in progress that would justify taking a long position. Conversely, when the MACD histogram is below the zero line and the ADX is above 25, it may indicate a strong downtrend that would suggest going short the market.
Advantages of the ADX in Trading
The ADX indicator offers several major advantages to traders, including the ability to help identify trend strength and potential reversals, determine trade entry and exit points and identify overbought or oversold levels.
- Identifying trend strength: Perhaps the most significant advantage of using the ADX in trading is its ability to help traders identify trend strength. By providing a numerical readout of trend strength, the ADX can give traders a clearer idea of whether a trend is likely to continue or reverse, especially when combined with a momentum indicator like the RSI to help a trader get a more complete view of market conditions. This feature can be helpful to traders in financial markets where trends can be particularly strong and persistent.
- Determining entry and exit points: Another benefit of the ADX is that it can help traders determine entry and exit points. By looking for divergences between the ADX and price action, traders can identify potential turning points in the market. For example, if the price makes a new high but the ADX fails to follow suit, it may indicate that the trend is losing steam and that it is time to exit a trend-following trade and perhaps even switch directions.
- Managing risk: ADX can help traders manage their risk by setting stop-loss and take-profit levels. By placing stop losses beyond recent swing highs or lows, traders can limit their potential losses if the market reverses unexpectedly. By setting their take-profit levels based on the strength of the trend as indicated by the ADX, traders can select more suitable levels to lock in profits that are more likely to be attained.
Limitations of ADX in Trading
While the ADX can be a useful technical indicator, it is not a perfect tool because it has limitations.
- Lagging indicator: One such limitation is that it is a lagging indicator and can produce untimely signals because it cannot respond immediately to changes in market conditions. This can lead to missed opportunities or unnecessary losses when using the ADX if traders are not careful to look for confirmation in other ways.
- Lacks direction of the trend: ADX does not provide information about the direction of the trend. While the ADX can tell traders whether a trend is strong or weak, it cannot tell them whether the trend will continue in the same direction or reverse.
- Less effective in ranging markets: The ADX also may not be as effective in ranging markets as it is in trending markets. Because the ADX measures trend strength in the market, it may struggle to identify profitable trades in ranging markets where the price or exchange rate is consolidating or moving sideways. This shortcoming can result in generating false trading signals in ranging markets.
Overall, while the ADX can be a valuable tool for traders, it is important to use it in conjunction with other indicators and to carefully manage risk. By combining the ADX with other tools and techniques, traders can maximize its potential and minimize its limitations.
Putting the Average Directional Index to Work for You
In conclusion, the ADX is an unusually valuable technical analysis tool for traders looking to analyze market trends and momentum. By understanding how to calculate and interpret the ADX, traders can identify trend strength, trade entry and exit points and potential market reversals.
Combining the ADX with other indicators, such as moving averages, RSI, Bollinger Bands and the MACD, can further enhance its predictive abilities. Still, traders should also remain aware of the ADX's limitations, such as its tendency to produce lagging signals and its limited applicability in ranging markets.
The advantages of using the ADX in a technical trading plan generally outweigh the disadvantages. By incorporating the ADX into your trading strategies, you can gain a competitive edge and increase your likelihood of success. Start exploring the possibilities of the ADX today and discover the power of using it for trend strength analysis.
Frequently Asked Questions
What does the ADX indicator tell you?
The ADX indicator provides insight into trend strength by measuring the degree of momentum in price movements over a specified period. It does not differentiate between bullish and bearish trends but rather focuses on the presence and intensity of underlying momentum.
What is the best setting for the ADX indicator?
Default settings for the ADX generally include a 14-period lookback window, which strikes a sensible balance between responsiveness and stability. Some traders may opt for longer or shorter durations depending on their particular time frame focus. Ultimately, the optimal ADX settings will depend on your preferences, current market characteristics and your intended usage within your trading plan.
What is the ADX for scalping?
Given its ability to measure trend strength, the ADX can prove useful in conjunction with other technical indicators during intraday scalping activities. However, because scalpers primarily target small price or exchange rate fluctuations within narrow timeframes, they should exercise caution when interpreting ADX signals to ensure adequate consideration of prevailing volatility and liquidity conditions.