Understanding the ADX Indicator
The Average Directional Index (ADX) is a technical analysis tool that measures the strength of a market trend. It does not provide information about the direction of the trend, but only the strength of the trend. Thus, whether a market is in an uptrend or downtrend, a high ADX value signifies a strong trend while a low ADX value demonstrates a weak or non-trending market.
The ADX indicator is an average of expanding price range values. Developed by J. Welles Wilder in 1978, it evaluates the difference between the highs and lows of recent price candles, using a specific algorithm to convert these values into a smooth ongoing line. This line usually ranges from 0 to 100 and primarily helps traders to identify periods when the trend might be strongest.
Components of the ADX Indicator
The ADX consists of three lines: the ADX line itself, plus the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). The +DI measures the strength of upward movement while the -DI measures the strength of downward movement. When +DI is above -DI, the market is in an uptrend, and when -DI is above +DI, the market is in a downtrend.
Using the ADX Indicator
Step 1: Understanding the scale
ADX is measured on a scale from 0 to 100. A trend is considered strong when the ADX is over 25, while a trend is weak or the price is moving sideways when the ADX is below 20.
Step 2: Identifying the trend direction
While the ADX does not provide the direction of the trend, you can use the +DI and -DI for this. If the +DI is above -DI, there’s more upward pressure than downward pressure. Conversely, if the -DI is above the +DI, there’s more downward pressure in the price.
Step 3: Combining ADX with other indicators
ADX is not a standalone trading system but rather a supplement to other trading systems. It can be combined with other indicators to confirm trade setups. For instance, if ADX shows a strong trend (greater than 25), traders can use trend-following strategies, such as moving averages or Bollinger Bands.
Trading with the ADX Indicator
Typically, traders use a series of rules or strategies with the ADX indicator. Below are some of the common ways traders use ADX:
1. Cross System: Traders pay attention to the +DI and -DI cross each other. If +DI crosses above the -DI, and ADX is above 25, the trader considers going long. Conversely, if the -DI crosses above the +DI, and ADX is above 25, the trader considers going short.
2. ADX and Momentum: Traders may consider entries when the ADX begins to move higher from below 20 levels. This could be the sign of a new trend beginning and increasing in momentum.
3. Volatility Fade: If the ADX is under 20 and the security is in a range, some range-bound or fading strategies could be considered. If a stock’s price moves to the upper range and then turns down, the trader may go short. And, if the price at the lower range moves up, the trader may go long.
While the ADX indicator can be a useful tool in identifying strong trends, like all indicators, it has its limitations. It is lagging and responds to market changes slower. Also, ADX values can stay high during choppy or corrective periods, so it is paramount to combine ADX with other signals and strategies to decrease false alarms. The best use of the ADX is to combine it with other indicators and use it as a confirmation tool to help you decide whether you should enter or exit a trade.
