The average directional index (ADX) is a charting tool that judges trend strength. It was formulated by market technician J. Welles Wilder and presented in his 1978 book New Concepts in Technical Trading Systems, along with the minus directional indicator (-DI) and the plus directional indicator (+DI).
Trading on a price trend can be profitable, but for some it may also be nerve-racking, especially given uncertainties in market movements that can arise to transform what seemed like a winning trade into a costly exercise. How can a trader feel confident that a trend is likely to continue, or will reverse to erase profits that looked to be in the bag? This is where the ADX can be utilised.
The ADX is represented as a value between 0-100, where the higher the value, the stronger the asset price is trending.
A Directionally Neutral Indicator
Contrary to what its name might suggest, the ADX is considered a directionally neutral indicator. This means it will tell you only the strength of a trend and not whether the trend is bullish or bearish.
How Is It Calculated?
The ADX is customarily calculated using the 14-period positive directional index and the 14-period negative directional index. When the difference between these two indicators widens, the average directional index increases; when the difference narrows, the ADX decreases.
How It Works
The ADX is typically presented in a line graph below price charts, similar to an oscillator. It can also appear as a separate graph together with +DI and -DI trend lines.
The ADX indicator can be applied to any asset price in any market. A higher value, generally above 30, means the asset price has been trending in a particular direction, either up or down; a lower value, below 30, means the asset price has been moving sideways. The ADX is particularly useful as a filter when you want to eliminate false signals and trades that potentially won't have the strength to remain on a trend for more than a short period of time.
The ADX measures not only trend strength, but also gives an indication of the intensity of a trend. When the trend is making a rapid move higher, the graph line on the index will make a steeper upward movement. Likewise, when the strength of a trend is quickly losing steam, the line will make a steep downward movement.
Ways To Use ADX
Spotting A Breakout
The ADX can be particularly helpful in spotting breakouts from range-bound conditions, especially in volatile conditions where momentary trends may be uncertain. Traders will want to look for a strong reading of the index, above 30, to verify that a breakout from a given range may be occurring. A reading of 40 or more is often considered a sure sign that a breakout has occurred and a trend has formed.
Moving Average Crossovers: Catching the Trend
Another popular way to use the ADX is in conjunction with moving average crossover signals. For example, if you are tracking a 20-period moving average against a 50-period average and receive a buy or sell signal at a crossover point between the two, you can check the strength of the ADX indicator to verify whether the trend ahead may justify a trade.
If the crossover occurs while the indicator is above 30, the trend will likely continue on its present direction for a sufficient movement to justify a trade. But if the indicator is below 30, it signifies that the price may move sideways, or that the trend may be weak and see a possible reversal in the short term.
In his book, Welles Wilder also suggested that crossovers of the +DI and -DI trend lines could be used as buy and sell signals.
ADX In Conjunction With Other Indicators
If you are still uncertain of the odds of a solid trade despite a signal from the technical indicator you are using, the ADX can serve as a backup to confirm the trend. In addition to complementing moving averages, the index is commonly used in conjunction with other indicators such as Fibonacci retracements, stochastic oscillators and Bollinger Bands.
With Fibonacci retracements, once a signal such as a 50% retracement is given, a strong ADX can help confirm if an upward or downward trend will be extended. Similarly, with a slow stochastic oscillator, if an oversold or undersold market signal is given on a chart, the ADX can be used to verify if momentum has stalled and a reversal is at hand.
With Bollinger Bands, the ADX indicator can help confirm if the reduction of volatility shown by a price outside of the bands is signaling the start of a new trend.
There are several manners in which to employ the ADX. Generally, traders will want to use it in trend trading as part of a strategy where they seek to identify whether or not a trend will continue sufficiently in a particular direction to make a profit on a trade.
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