Average Directional Index (ADX) is used to evaluate the strength of the trend. ADX indicates the strength and +DI and -DI makes it directional. Have an in-depth understanding of this technical analysis indicator for Forex trading.
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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 and not whether the market has uptrend or downtrend. The direction indication comes by the +DI and -DI lines which are associated with this indicator.
ADX or Average Directional Index tells us if there is a trend (up or down) or the market is moving sideways i.e. is lacking any real trend. Please note that the explanation here is focused around Forex trading but the same is equally valid for stocks of any commodity trading.
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. Please again note that ADX does not tell us if trend is an uptrend or a downtrend. It just tells us the strength of the trend.
ADX is used as one of the trend identification indicators in technical analysis. As mentioned above, ADX tells us whether the market is trending or it is running sideways. The +DI and -DI lines of ADX indicator indicate the type of trend is there i.e. up or down. We also get buy and sell signals from ADX. The uses are described as follow.
|ADX Reading||Trend Situation|
|Above 25||The market is trending|
|Above 25 and going up||Trend is getting stronger|
|ADX Below 25||The market is running in range (ranging)|
ADX readings tell us whether there is a trend or not. But if there is a trend, it does not indicate if it is an uptrend or downtrend. Here +DI and -DI lines come handy.
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. When it is above 25 and –DI line is above +DI line then it indicates a downtrend.
ADX Indicator is used for trend recognition and to know the strength of the ongoing trend but ADX crossover buy and signals come from the crossover of +DI and -DI lines.
1) +DI line moving upwards: When +DI crosses –DI upwards to 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 say daily chart before taking a decision on shorter period chart, say hourly 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 sideways market or trend lines (green arrow touching the support & resistance levels during trending market in above diagram, then you get an even better picture about what the ADX is implying.
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 nor 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.
While ADX is not a directional indicator, the DI (Directional Indicators tend to tell us about the direction of the trend. 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 observe as to which line is at what number and whether +DI line is crossing –DI line upwards or vice versa.
We do not need to memorize the following technicalities about ADX 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 = SUM[(+DI-(-DI))/(+DI+(-DI)), N]/N
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 line of ADX (Average Directional Index) crosses up over the -DI line. A sell signal is generated when the -DI line crosses up over the +DI line.
ADX 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) are going higher than the previous ones, it may give a good signal for an emerging uptrend.
The quite preferred setting for the ADX is 14 periods, which means if we were to calculate ADX on a daily chart we would consider the closing prices of past 14 days, and in the case of an hourly chart, we would take into account the closing prices of past 14 hours. The default setting of 14 is common to several popular indicators, such as Relative Strength Index (RSI).
In volatile market short period settings may be better for ADX but its better to stick to once period setting as with time we start to have a feel about it.
We explained ADX (Average Directional Index) indicator in the context of Forex trading but the same stands good for stock trading or any commodity trading.
Check some thoughts about ADX and RSI Trading Strategies.
You may also check some more trading strategies using ADX with stochastic and Bollinger Bands.
Some more technical analysis strategies by using ADX with SAR, RSI and MACD.