How to Trade Using Average Directional Index (ADX)

What is the ADX Indicator?

The ADX, which stands for Average Directional Index, is an oscillator used in technical analysis to identify market trends and measure their strength. Unlike other oscillators, the ADX does not determine a trend’s direction, meaning that it is often used in conjunction with other indicators that provide traders with clearer buy and sell signals.

How the Average Directional Index Works

As an oscillator, the ADX indicator fluctuates in value between 0 and 100. Readings below 20 indicate a weak, or non-existent trend, whereas readings above 40 signal a strong trend.

Average Directional Index (ADX)

By following the interpretations provided by the ADX trend indicator, investors are able to anticipate and react to potential movements in the market. Traders looking to profit from trends can use the Average Directional Index to identify the best time to enter the market, and when to play the waiting game. However, as the ADX doesn’t signal the direction of a market trend, other indicators must be used to help investors know when to buy and when to sell. An example of this would be to use the Average Directional Index in combination with the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI), which would help determine the direction of emerging market trends. The +DI and -DI indicators were created by ADX developer, J. Welles Wilder, to be used in conjunction with the Average Directional Index, forming a complete trading system known as the Directional Movement System or Directional Movement Index.

How to Use the ADX Indicator

Average Directional Index (ADX)

In the example above, we can see that the asset price was trading within a range, before experiencing a significant uptrend. The ADX trend indicator returned values below 20 prior to the breakout, indicating the lack of any strong trend, only to rise and move above 40 as the trend began taking shape. There are multiple ways in which investors could have taken advantage of this data. If the Average Directional Index was being supplemented by the use of other indicators that signal the direction of a trend, a trader could have opened a buy position when the ADX rose above 20. Alternatively, if an investor was focusing solely on the data provided by the ADX, they could have waited for the asset price to confirm the direction of the trend taking place, before placing a buy order when the indicator crossed 40. As seen, the ADX value remains above 40 for a significant period, indicating the continuation of a strong trend, but subsequently begins to fall, first crossing below the 40 mark, and then below 20. Investors following this data could have closed their trade with a sell order when the ADX crossed below 40, or waited for definite confirmation that the trend had ended when the indicator reached 20.

How to Calculate ADX

As the Average Directional Index (ADX) is only one part of the Directional Movement Index, which includes the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI), the method for calculating it is fairly complex. The ADX indicator’s formula is as follows:

ADX = 100 x the smoothed moving average of the absolute value of [(+DI) – (-DI)] / [(+DI) + (-DI)]

For the calculation of +DI and -DI, you need price data including the high, low and closing prices of the asset for each period. You must then calculate directional movement (+DM and -DM):

Upward Movement (UP) = today’s high - yesterday’s high

Downward Movement (DW) = yesterday’s low - today’s low

IF (UP) > (DW) AND [(UP) > 0] THEN (+DM) = (UP) ELSE (+DM) = 0

Formula Explained: If the value of Upward Movement (UP) is greater than the value of Downward Movement (DW), and the value of Upward Movement (UP) is also greater than zero, then the value of Positive Directional Movement (+DM) is equal to the value of Upward Movement (UP). If, however, these criteria are not met, then the value of Positive Directional Movement (+DM) equals zero.

IF (DW) > (UP) AND [(DW) > 0] THEN (-DM) = (DW) ELSE (-DM) = 0

Formula Explained: If the value of Downward Movement (DW) is greater than the value of Upward Movement (UP), and the value of Downward Movement (DW) is also greater than zero, then the value of Negative Directional Movement (-DM) is equal to the value of Downward Movement (DW). If, however, these criteria are not met, then the value of Negative Directional Movement (-DM) equals zero.

Having calculated the values of directional movement, you need to select the number of periods to be used, the default for which is usually 14 bars, and then calculate +DI and -DI:

+DI = 100 x the smoothed moving average of (+DM) / average true range

-DI = 100 x the smoothed moving average of (-DM) / average true range

Once you have the values for +DI and -DI, you can go on to calculate the Average Directional Index using the indicator’s formula provided above.

ADX Indicator Settings

Investors looking to apply the ADX trend indicator to their chart analysis will have to select the number of periods over which the indicator will be calculated. The default is usually set to 14 bars. This, however, can be adjusted for investors that trade longer or shorter timeframes. A higher setting may provide more reliable signals, but might also identify trends too slowly, limiting the potential for profit. Conversely, a lower setting could help identify trends faster, but may also provide less reliable signals, potentially reducing the effectiveness of the indicator.

How to Use the ADX Indicator in Real Trading Conditions

Having covered the basics, let’s take a look at how to use the ADX indicator in real trading conditions. Below is a chart showing the performance of the GBP/USD currency pair in the Forex market between February and May 2016. The pair has been charted at a daily timeframe, and the period for the ADX has been set to the default value of 14.

Average Directional Index (ADX)

In the highlighted section, the asset price is observed to follow a pattern of consolidation. No major trends take place and the price remains within well-defined levels. This interpretation is mirrored by the ADX, which fails to rise above 20 throughout the period, confirming the lack of a strong trend.

Average Directional Index (ADX)

Focusing on a different period on the chart, we can see that the asset price suffers a sudden drop. The ADX indicator registers the trend, rising above 20 and falling narrowly short of the 40 point. This movement helps confirm the presence of a trend, which although not very strong, may provide a profitable opportunity for Forex traders that take advantage of it. Remember that the ADX is only able to hint at the existence and strength of a trend, so investors following this movement would have had to wait for the asset price to confirm direction, or use another indicator for a clearer sell signal.

Average Directional Index (ADX)

Finally, returning to an earlier period on the chart, we can see the emergence of a strong trend in the highlighted section. The asset price experiences a steady, but fairly significant decline, a trend that is confirmed by the ADX. It crosses above 20, which confirms the appearance of a trend, and continues to rise well above 40, indicating the strength of the trend. Subsequently, the trend begins to lose momentum, with the ADX indicator dropping back below 40, before once again reaching the 20 point, signalling the end of the trend. Investors that had correctly identified and traded this trend would have earned a sizeable profit.

Conclusion

As we have explained, the Average Directional Index is a useful technical analysis tool that can help investors identify new market trends and measure their strength. As a standalone tool, the main drawback of the ADX is its inability to provide signals on trend direction, meaning traders have to supplement its use with other indicators that offer clearer buy and sell signals. However, this issue is addressed by the Directional Movement Index, which combines the Average Directional Index with the Positive and Negative Directional Indicators, creating a complete trading system that provides investors with all the signals they should need to trade market trends.

Did you know?

Currency trading and exchange are no new practices. In fact, money-changing people can be traced back to the Biblical times. Using city-stalls, they would help others change money and take a commission or charge a fee for their services.

Word of the day
"Basis Point (BP)" - A measure unit for interest rates which equals 0.01% and shows the percentage change in a financial instrument.
Pro Tip

Trades usually have more chances of being successful during high market activity.

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