The Average Directional Index, or short ADX, is developed by Welles Wilder. His trading system is designed to be a trend indicator that can help traders in specifying the market. Especially for stock trading, where there is an overload of different graphs to review, the ADX can help traders quickly determine what potential interesting stocks to trade are. But also for forex markets the ADX is an important tool that can be used to support your decision making and improve your trading results. Let’s see how we can use the ADX in our favor
First of it is important to realize that the ADX is a trend indicator. It measures the strength of a trend and therefore, is useful to determine whether the trend is weak or strong. High ADX values indicate that there is a strong trend, while low readings suggest there is a weak trend. So it measures strength of a trend, but it does not tell you if the trend is up or down. It can either be a strong uptrend or a strong downtrend. It is important to keep that in mind.
The ADX, is the value of an equation which considers values of a group of directional movement indicators, called Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI). Both the –DI and +DI are input variables to get the DX value which is averaged in order to get to the ADX (average DX).
The equation below shows the calculation of the DX for a 14-period time frame, which is most commonly used.
This equation simply symbolizes the difference between the positive and negative strength by the total strength in the market. This means that if for the selected time period there was a big difference between the positive and negative powers in the market we get a high DX-value. We could see straightaway that it doesn’t matter if the difference comes from up- or downwards pressure in the market. Once the +DI and –DI values are in balance it means that the market is indecisive, giving a low value in the numerator and therefore resulting in a low DX-value.
The ADX can easily be directed from the DX since it is just a moving average of the DX values. The advantage is that it smoothens the DX which can be very volatile. The number of periods used to smoothen the DX is generally the same as used for calculating the DX in the first place.
Once more I’d like to stress that the ADX is increasing in a strong up- & downtrend! The ADX is sloping down only when the trend is losing strength.
The ADX values scale between 0 and 100. Often the software package only mark 0 through 80. As guideline for what the values tell about the strength of the trend I use the following:
|It is in a trading range. It moves roughly sideways.|
|Once it moves above 25 a starting trend should occur. Often we see big moves up or down occur around this level.|
|Values above 30 indicate a strong trend. This provides often great trading opportunities.|
|Rarely we would see values of >50. If we do see them, be wary! There is a big chance the trend is at its end.|
Trading the ADX-indicator
A common way of using this indicator to generate trading signal is by waiting for crosses above the 25-level in combination with the position of +DM vs. –DM. The market is considered trending up when +DM > -DM, and trending down if +DM < -DM.
So one simple trading system could be:
- BUY: when ADX is above 25 & +DM is above –DM
- SELL: when ADX is above 25 & +DM is below –DM
(Do your own back testing before executing such strategy!)
Since the ADX is built on moving average (MA) components, it has like MA the disadvantage that it can give late signals. It is therefore likely that it will not provide effective entry and exit points.