ADX (Average Directional Index) Indicator for Technical Analysis in Forex Trading:
The ADX (Average Directional Index) was developed by J. Welles Wilder
ADX is one of the technical indicators to help determine if the market is ranging or trending. Please note that this indicator only indicates the strength of a trend in Forex trading and not whether the market has uptrend (bullish) or downtrend (bearish).
ADX tells us if there is a trend (up or down) or the currency pair is moving sideways or in range.
Technical Analysis - Average Directional Index (ADX) (Forex Abode.com)–Fig1:
In the above picture there are three lines at the bottom. One is +DI line, another –DI line and the third is ADX(14) (14 means 14 periods :- “period” information is at the bottom of this article). We shall explain +DI and –DI line later.
ADX has a range from 0 to 100 but it rarely goes above 60. A higher number shows a strong trend while a low number shows weaker trend for the currency pair. Please again note that ADX does not tell us if trend in the Forex market (for the concerned currency pair) is an uptrend or a downtrend. It just tells us the strength of the trend.
ADX Readings:
1) Above 25: The market is trending
2) Above 25 and going up: Trend is getting stronger
3) Below 25: The market is running in range (ranging)
ADX Indicator for Technical Analysis in Forex trading- How do we know if its uptrend or downtrend:
The ADX is used with +DI and –DI lines. Generally +DI line would be in green and –DI line would be in red.
When ADX is above 25 and +DI line is on top of (above) –DI line then it indicates an uptrend and when ADX is above 25 and –DI line is above +DI line then it indicates a downtrend.
How ADX and +DI and –DI line suggest buying or selling points for the currency pair:
1) +DI line moving upwards: When +DI line below –DI line crosses and come above the –DI line, it indicates a reversal towards uptrend and hints buying or to close down the already short sold positions.
2) –DI line moving upwards: When -DI line below +DI to crosses and comes above the +DI line, it indicates a reversal to downtrend and hints short selling or to close down the already bought open positions.
3) It may be a good idea to take the decision after noting the ADX on bigger time frame (daily forex chart, 3 or 4 hourly chart or 1 hourly chart before taking a decision on shorter period chart. Bigger time frame chart will give us a broader picture of the longer term trend. In simple words the short term chart may show that the trend is weakening but a longer term chart may say that the drop is just a temporary correction and the trend still exists.
If we couple the ADX reading with support/resistance lines (red parallel lines in above diagram) in a ranging (sideways) forex market or trend lines (green arrow touching the support & resistance levels during trending forex market in above diagram, then you get an even better picture about what the ADX is implying for that currency pair.
When the ADX is below the 25 level (the dotted straight line on the chart), it is considered to be a market moving in range or sideways i.e. neither bullish run or bearish run. At such times, we may use other ranging indicators such as the RSI or Bollinger Bands. We can and should always draw the somewhat horizontal support/resistance (in above diagram red) lines when the market is moving in a range.
Technical Analysis - Average Directional Index (ADX) (Forex Abode.com)–Fig2:
Directional Movement Index (+DI and -DI)
While ADX is not a directional indicator, the DI (Directional Indicators tend to tell us about the direction of the trend for the currency pair. Unlike the old days, we do not have to worry about the calculations and definitions behind various technical indicators. The trading platforms come with all these indicators. We just need to select the indicators and watch as to which line is at what number and whether +DI is crossing –DI upwards or vice versa.
We do not need to memorize the following technicalities but just for ready reference:
The +DI is the percentage of the true range that is up or the range of highs divided by the price range over the last period and previous close, smoothed over a given number of periods.
The -DI is the percentage of the true range that is down or the range of lows divided by the price range over the last day and previous close, smoothed over a given number of periods.
ADX is calculated as follows:
ADX = SUM[(+DI-(-DI))/(+DI+(-DI)), N]/N
Where:
N = The number of periods used in the calculation (i.e 14 period on a hourly chart means 14 hours and 14 period on a daily chart means 14 days)
A buy signal is generated when the +DI crosses up over the -DI. A sell signal is generated when the -DI crosses up over the +DI.
Forex trading signals are also generated or get further confirmed by Divergences.
Divergences: when the subsequent high or low points (peaks and valleys) of ADX line are going lower than the previous peaks. It may give a good signal for an emerging down trend. Similarly if the subsequent high and low points (peaks and valleys) of ADX line are going higher than the previous ones, it may give a good signal for an emerging uptrend.
Period setting in Forex technical analysis indicators:
in Forex trading the quite preferred setting for the ADX indicator is 14 periods, which means if we were to calculate ADX on a daily chart we would measure 14 days, and in the case of an hourly chart, we would measure 14 hours. The default setting of 14 is common to several popular indicators, such as Relative Strength Index (RSI) and Average True Range (ATR).
In volatile market short period settings may be better but its better to stick to once period setting as with time we start to have a feel about it.
We explained Parabolic ADX (Average Directional Index) in the context of Forex Trading but the same stands good for stock trading or any commodity trading.
