- What is the ADX
- ADX Calculation
- Reading the ADX Indicator
- Trading ADX Signals
- Combining ADX with Other Indicators
- Trading with the ADX Indicator at AvaTrade
Created by legendary trader Welles Wilder in 1978, the Average Directional Movement Index (ADX) is a technical analysis tool used by traders to establish trend strength as well as trend direction. It is common investing wisdom that detecting and trading in the direction of a strong trend is a profitable strategy with minimal risk exposure. This is why ADX is one of the most popular indicators among traders of all levels.
Functionally, the ADX is an excellent indicator for identifying the prevailing conditions in the market. Traders can easily determine whether a market is ranging or trending, and then apply the appropriate technical trading strategy.
The ADX indicator has 3 lines: +DI (green line), -DI (red line) and ADX (black line). These lines are calculated using the formulas below:
+DI = ((Smoothed MA + DM)/ATR) * 100
-DI = ((Smoothed MA – DM)/ATR) * 100
DX = ((+DI – -DI)/(+DI + -DI)) * 100
First ADX = sum n periods of DX / n
After that ADX = ((Prior ADX * n-1) + Current DX) /n
+DM = Current High – Previous High
-DM = Previous Low – Current Low
ATR = Average True Range
N = Number of periods used in the calculation (the default is usually 14 but traders can adjust this according to their needs)
The above calculation will plot the three lines of the ADX indicator. The +DI (green line) will be the positive directional indicator, whereas the –DI (red line) will be the negative directional indicator. The ADX (black line) is a non-directional indicator (essentially the average difference between +DI and –DI) and is plotted from 0 to 100, with no negative values.
Reading the ADX Indicator
As mentioned above, the ADX line is primarily a momentum indicator. Based on this, a rising ADX implies a strengthening trend, whereas a falling ADX implies a weakening trend. Welles provided the ADX trend strength scale as below:
|ADX Value||Trend Strength|
|0-25||Non-trending market or range-bound market|
|50-75||Very strong trend|
|75-100||Extremely strong trend (rarely happens and can be considered unsustainable)|
Trend direction is determined by watching the +DI and -DI lines. An uptrend is in place when the +DI is above the -DI; whereas a downtrend is in place when -DI is above the +DI. When +DI and -DI crosses, it indicates that a trend reversal is occurring.
The trend is turning bullish if +DI is crossing above -DI; similarly, the trend is turning bearish if -DI is crossing above +DI. It will be a case of a particularly strong trend if a cross occurs when the ADX line is also going up.
Trading ADX Signals
The ADX delivers several price signals that can be traded in the market and learning how to trade these signals, could enhance your trading accuracy. These signals include:
The main aim of using the ADX is to only focus on trading qualified opportunities in trending markets. This is why it is important to watch out for crossovers of the +DI and –DI lines. When the +DI crosses above the –DI line, it implies that the rate of positive price change in the market is greater than the negative price change. If this happens when the ADX is above 25, it is a solid signal to place buy orders. Similarly, when the -DI crosses above the +DI line, it implies that the rate of negative price change in the market is greater than the positive price change. If this happens when the ADX is below 25, it is a solid signal to place sell orders.
Crossovers are as much a trigger of trade entry as they are for trade management and exits. For instance, if you are in a long position and the –DI line crosses above +DI, you can seek to protect your capital by locking in partial profits using trailing stops or by exiting your trade position entirely.
- Finding Ranges
The ADX is a trusted range finder in the markets. When the ADX reading falls below 25 and stays there for an extended period, it means that the market is trendless or basically ranging. Ranging markets are characterised by the price bouncing off recognisable support and resistance areas. In such markets, buy orders are placed off support areas, while sell orders are placed off resistance areas.
A ranging market is bound to break out eventually. Breakouts frequently happen in the markets, and they can offer a big opportunity for traders. Although breakouts can easily be spotted, it can be very difficult to determine whether a breakout is valid or not. There are far too many fake breakouts that can literally leave traders trapped in a bad trade position. The ADX helps to validate breakouts. That is, when the price breaks out with an ADX reading of above 25, it implies that momentum in the new direction can be sustained. But a breakout with an ADX reading of below 25 is potentially unsustainable.
Combining ADX with Other Indicators
ADX has some weaknesses that make it unsuitable to be used as a standalone indicator. To start with, it is based on moving averages, which means that it is largely a lagging indicator that reacts slower to price changes in the market. ADX is also practically inefficient when trading less volatile or ranging markets. Furthermore, ADX crossovers can happen frequently and deliver choppy signals to traders.
The idea is to combine the ADX with a complementary indicator that will provide a comprehensive analysis of an asset’s price. It is important to ensure that you do not combine the wrong indicators, which can lead to indicator redundancy and overemphasising information.
Indicator redundancy is when multiple indicators are used to measure similar price elements – for instance, using the ADX to gauge trend momentum and using Stochastics for the same purpose. A wrong combination can also lead to laying more emphasis on a single price element while overlooking other crucial cues.
In the above case, a trader could land up focusing on trend momentum while overlooking other important elements such as volatility.
Here are some of the best indicator combinations with ADX that will deliver higher probability trading signals:
- ADX and RSI
ADX indicator values of below 25 show that the underlying market is not trending. This is basically a market that requires range-bound plays. As an oscillator, RSI delivers overbought and oversold trading signals. An RSI reading of above 70 implies overbought conditions, whereas a reading of below 30 implies oversold conditions. A buy order in a ranging market will be when the price is drifting lower, with an ADX reading of below 25, and when the RSI is showing oversold conditions. Similarly, a sell order can be placed when the price is edging higher, with an ADX reading of below 25 and when the RSI is showing overbought conditions.
- ADX and Parabolic SAR
Parabolic SAR is a leading trend following indicator, and when combined with ADX, it could help traders to capture maximum returns in a trending market. ADX crossovers can take time to form in the market, and traders can enter a trending market early with Parabolic SAR when 3 consecutive parabolas are printed in the direction of the trend. Similarly, an early exit signal can be identified by Parabolic SAR when the parabolas flip onto the opposite side of the trend. This can be used instead of waiting for the +DI and -DI crossovers.
- ADX and MACD
The Moving Average Convergence Divergence (MACD) indicator is used to determine trend direction, its strength as well as a possible reversal. When the MACD and ADX are combined, the former is best utilised to detect reversals, with the latter qualifying them. A signal to buy will be triggered when the MACD rises above the zero, line with the ADX rising above 20 and the +DI line crossing above –DI line. Similarly, a signal to sell will be triggered when the MACD falls below the zero line, with the ADX rising above 20 and the -DI line crossing above the +DI line.
Trading with the ADX Indicator at AvaTrade
- Demo Account. A free demo account to give traders the opportunity to try out different ADX strategies without putting any money on the line.
- Choice of Assets. Apply ADX strategies on over 1,000 financial assets that include Forex, Stocks, Commodities, Stock Market Indices and Cryptocurrencies.
- Unparalleled Trading Environment. From advanced, robust and feature-packed trading platforms to efficient payment systems and excellent customer care, AvaTrade ensures that you can focus on your trading activities within a secure trading environment.
Main ADX Indicator Trading Strategies FAQ
What is the ADX Indicator?
The Average Directional Index, or ADX, is a trend indicator that is used to quantify the strength of a trend. It is plotted as a single line with a value between 0 and 100. Unlike other trend indicators the ADX is non-directional, meaning it simply register the strength of the trend, not whether it is an up-trend or a down-trend. In order to indicate whether prices are moving higher or lower the ADX Indicator is plotted with the +DMI and –DMI lines from which the ADX is derived.
What is the best ADX Indicator trading strategy?
A simple and effective strategy that is used by many traders is a crossover strategy that uses the ADX in combination with the +DMI and –DMI lines. In this trading strategy an order is placed whenever the +DMI and –DMI lines cross, as long as the ADX is also above 25, indicating a strong trend. When the +DMI line crosses higher it is a buy signal and when the –DMI crosses higher it is a sell signal.
What other indicator works best with the ADX Indicator?
The ADX Indicator actually works best when combined with other technical indicators. One of the best combinations is with the Relative Strength Index, or RSI. Because the ADX measures the intensity of the trend the RSI can help with entries and exits by giving a time based component to the trend. In this case traders should wait for confirmation of a downtrend by an RSI reading of less than 30, or confirmation of an uptrend by an RSI reading above 70 before placing an order.
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** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.