How to Use the Average Directional Index (ADX) Indicator

Trend trading is a popular forex strategy, especially among beginners. When the price shows a clear direction, upwards or downwards, that’s your opportunity to ride the tide. Riding a strong trend can lower risk. However, ensuring that the trend is indeed strong enough to ride is paramount. This is where the Average Directional Index or ADX indicator helps.

Understanding the ADX Indicator

ADX is a lagging technical indicator that helps determine the strength of a trend. The average directional index indicator quantifies the strength of an ongoing trend using moving averages on the price range expansion over a given timeframe. The default timeframe is 14 days, although you can customise the period according to your trading strategy. ADX is plotted below the price chart and ranges between 0 and 100.

Plotting and Interpreting the ADX indicator

The ADX indicator consists of 3 lines, calculated using the average true range (ATR) and directional index (DI) for the period under consideration.

Calculating ADX

ATR (average true range) = (Previous ATR x (n-1) + TR) / n

Where:

n = number of periods

TR = True range = Current high – Current low

ATR is sometimes also called smoothed TR.

Here’s how it is used to plot ADX:

+DI (positive directional index) = ((Smoothed MA + DM)/ATR) * 100

-DI (negative directional index) = ((Smoothed MA – DM)/ATR) * 100

DMI/ DX (directional movement index) =  (( |+DI – -DI | ) / ( |+DI + -DI | )) x 100

Where:

First ADX = Sum of DMI over n periods / n

After that, ADX = ((Prior ADX * n-1) + Current DX) /n

Seams tedious? Don’t worry, you don’t have to calculate or set the formula manually. Reputed brokerages provide the technical analysis tool as a ready-to-use indicator on their trading platform. Traders can simply drag and drop it to add to the price chart. The number of periods (n) and the duration of each period (1 minute, 1 hour, 1 day, etc.) can be adjusted.

Interpreting ADX Values

0 – 25: Market is range-bound

25 – 50: Trend strength is good

50 – 75: Strong trend, usually a good time to ride even if you are a late entrant

75 – 100: This is a rare event and indicates that the trend is very strong.

Strategies for Trading the ADX

Traders use the ADX for several technical analysis purposes:

Identifying Buy Opportunities

The crossover of the +DI above the -DI indicates that the rate of positive price change is greater than the rate of negative change. If this happens when ADX > 50, it is considered a strong signal to buy or exit sell positions.

Identifying Opportunities to Sell

When the -DI crosses over the +DI, the negative price change is faster than the positive price change. When this is accompanied by ADX < 25, traders popularly go short or exit their long positions.

Identifying Range-Bound Markets

When ADX sustains below 25 for a considerable time, traders switch to range trading strategies. Range trading strategies involve combining on balance volume (OBV), volume price trend (VPT), money flow index (MFI) and accumulation/distribution with the ADX indicator.

Buy orders are usually placed when the price is close to the support level while sell orders are placed when the price is in resistance area.

Identifying Range Breakouts

Sideways markets eventually break out and this happens when the trend strength is high. While Bollinger Bands and RSI are popularly used to identify breakouts, they can generate false signals. ADX > 25 accompanying a breakout indicates that the momentum is likely to be sustained. This is a signal to ride the trend in the direction of the breakout.

Limitations of the ADX Indicator

Things to keep in mind while using the ADX indicator for technical analysis include:

• ADX relies on moving averages, which makes it a lagging indicator. It introduces delays in trading decisions. Forex traders must, therefore, include other indicators (usually leading) in their trading strategy to make informed decisions.

• ADX does not specify the direction of the price trend. It can only tell you whether the ongoing trend is strong or weak. Combining it with trend indicators, such as Bollinger Bands, MACD (moving averages convergences divergences) and RSI (relative strength index), can be help identify the trend.

• ADX does not work well in sideways markets. Traders must determine when a particular indicator is useful. Switching to more horizontal trend-friendly indicators is better when the price moves within a range.

• Like most other technical indicators, ADX is also not sufficient alone. Experienced traders always combine it with other indicators to develop well-rounded trading strategies.

Combining ADX with Other Technical Indicators

Traders combine ADX with several popular indicators, such as:

ADX + MACD

MACD identifies the trend direction while ADX signals its strength. This helps traders determine entry positions within the trend.

ADX + RSI

RSI indicates the momentum and ADX indicates the strength. The two indicators help traders determining optimal entry and exit points.

To Sum Up

• The Average Directional Index is a lagging trend strength indicator.
• A value above 50 indicates a strong trend.
• ADX does not identify the direction of the trend.
• It can be used to identify buy, sell and exit signals.
• Combining ADX with other technical indicators can strengthen a trading strategy.

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