The average directional index (ADX) is a technical analysis indicator used to determine the strength of a trend. The trend can be either up or down, as depicted by two accompanying indicators: the negative directional indicator (-DI) and the positive directional indicator (+DI). Therefore, the ADX typically comprises three separate lines. These lines help traders assess whether to take a long or short position, or if a trade should be avoided entirely.
Key Takeaways
- Developed by Welles Wilder for commodity daily charts, the ADX is now widely used in various markets by technical traders to gauge trend strength.
- The ADX incorporates a positive (+DI) and negative (-DI) directional indicator in addition to the trendline.
- According to Wilder, a trend has notable strength when the ADX is above 25; conversely, it reveals a weak trend or trendless state when below 20.
- A non-trending state doesn’t imply insignificant price movement; the price could be experiencing a trend change or high volatility.
Average Directional Index (ADX) Formula
The ADX requires multiple calculations due to its composite structure.
+DI = \ rac{{\text{Smoothed +DM}}}{\text{ATR}} \ imes 100
-DI = \ rac{{\text{Smoothed -DM}}}{\text{ATR}} \ imes 100\
DX = \ rac{{|+DI - -DI|}}{{|+DI + -DI|}} \ imes 100
ADX = \ rac{{(\text{Prior ADX} \ imes 13) + \text{Current ADX}}}{14}
+DM (Directional Movement) = \text{Current High} - \text{Previous High}
-DM (Directional Movement) = \text{Previous Low} - \text{Current Low}
ATR = \text{Average True Range}
Calculating the ADX
- Calculate +DM, -DM, and the true range (TR) for each period, typically using 14 periods.
- +DM = current high - previous high.
- -DM = previous low - current low.
- Use +DM when current high - previous high > previous low - current low. Use -DM when previous low - current low > current high - previous high.
- TR is the highest value between the current high - current low, current high - previous close, or current low - previous close.
- Smooth the 14-period averages of +DM, -DM, and TR.
- First 14TR equals the sum of the first 14 TR readings.
- Next 14TR value is computed as follows: First 14TR - (prior 14TR/14) + current TR.
- Divide the smoothed +DM value by the smoothed TR value to obtain +DI, multiplied by 100.
- Divide the smoothed -DM value by the smoothed TR value to obtain -DI, multiplied by 100.
- The directional movement index (DMI) is +DI minus -DI, divided by the sum of +DI and -DI, and multiplied by 100.
- Calculate DX values for at least 14 periods to get ADX; first ADX equals the sum of 14 DX periods divided by 14.
- Subsequent ADX values are computed thus: ADX = ((prior ADX \ imes 13) + current DX) / 14.
Unleashing the Potential of ADX
Decoding the Signals
The ADX, negative directional indicator (-DI), and positive directional indicator (+DI) reveal market momentum. The ADX pinpoints trend strength, while -DI and +DI determine trend direction.
A strong trend is when the ADX is above 25, while a weak trend is when the ADX is below 20. Crossovers involving the -DI and +DI lines generate trade signals. For instance, if the +DI line crosses above the -DI line and the ADX is above 20 or preferably 25, traders consider buying. Alternatively, if the -DI crosses above the +DI, it may be an opportune moment to initiate a short trade.
Crossovers can guide trade exits. For example, if in a long position, exit if the -DI crosses above the +DI. When the ADX dips below 20, it’s indicating that the market lacks a decisive trend, suggesting potential trades might not be favorable.
ADX vs. Aroon Indicator
The ADX indicator uses three lines, whereas the Aroon indicator employs two. Both indicators identify trend direction via positive and negative movements and gauge trend strength. However, due to different calculation methods, their crossover signals occur at varied instances.
Recognizing ADX Limitations
Frequent crossovers may generate confusion, potentially leading to losses from sudden market reversals—known as false signals—occurring mostly when ADX values are below 25. Consequently, ADX should be combined with price analysis and other indicators to improve signal reliability and manage risks.
Further Insights
Optimal ADX Values
An ADX above 25 signifies a strong trend. Below 20, it indicates a weak or trendless condition.
Evaluating ADX as an Indicator
The ADX proves effective, especially when integrated with price analysis. Investors should use ADX to identify trending or non-trending phases and apply suitable trading strategies accordingly.
Best Complementary Indicator
The relative strength index (RSI) pairs well with ADX. While the ADX measures trend intensity, the RSI aids entry and exit timing, complementing the trend analysis.
Conclusion
The average directional movement index (ADX) serves as a key instrument for traders to gauge trend strength and direction. By using ADX, traders can discern if a market is trending or ranging and apply suitable trading strategies. ADX is often used alongside other technical indicators like parabolic SAR, moving averages, and envelopes to formulate robust trading strategies with minimal risk, hence its popularity among traders.
Related Terms: trend strength, positive directional indicator, negative directional indicator, relative strength index, RSI, Aroon indicator.
References
- E. Ponsi. “Technical Analysis and Chart Interpretations: A Comprehensive Guide to Understanding Established Trading Tactics”, Pages 283-287. John Wiley & Sons, 2016.
- Avatrade. “ADX Indicator Trading Strategies”.
