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. ADX belongs to the broader group of trend-following indicators. Other technical analysis indicators similar to ADX include the Parabolic SAR, Envelopes and Moving Averages.
1. Calculation of the ADX:
The ADX is derived from the Directional Movement Index (DMI), which consists of three lines: Positive Directional Indicator (+DI), Negative Directional Indicator (-DI), and the ADX itself.
Here’s a brief overview of the calculation process:
I. True Range (TR):
- Calculate the True Range, which represents the greatest of the following:
A. Current High minus the current Low
B. Absolute value of the current High minus the previous Close
C. Absolute value of the current Low minus the previous Close
2. Directional Movement (DM):
- +DM is the current High minus the previous High, if positive; otherwise, it is zero.
- -DM is the previous Low minus the current Low, if positive; otherwise, it is zero.
3. Smoothed Average of +DM and -DM:
- Calculate the 14-period smoothed averages of +DM and -DM using the Wilder’s smoothing formula.
4. Directional Index (DX):
- Compute the Directional Index, which is the absolute difference between +DI and -DI divided by their sum, multiplied by 100.
5. Average Directional Index (ADX):
- Finally, calculate the ADX by smoothing the 14-period DX using the Wilder’s Smoothing formula.
II. Interpretation of ADX:
The ADX is a scale ranging from 0 to 100, where higher values indicate stronger trends. Traders typically use the following interpretations:
- 0-25: Indicates a weak or non-existent trend.
- 25-50: Suggests a developing trend, whether bullish or bearish.
- 50-75: Signifies a strong trend.
- 75-100: Indicates an extremely strong trend.
The ADX also helps traders identify the strength of a trend by comparing it with other technical indicators and price action.
III. Practical Applications:
- Trend Identification: Traders use ADX to identify the presence and strength of a trend in the market. A rising ADX suggests a strengthening trend, while a falling ADX indicates a weakening trend or a potential reversal.
2. Crossovers:
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.
3. Finding Ranges and Trend Strength:
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 characterized by the price bouncing off recognizable support and resistance areas. In such markets, buy orders are placed off support areas, while sell orders are placed off resistance areas.
Furthermore ADX values can help traders gauge the strength of a trend, allowing them to make decisions about entering or exiting positions. High ADX values are often associated with strong trends, while low values may indicate a lack of trend strength.
4. Breakouts:
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.
Trend Reversals:
- Crossovers between +DI and -DI, along with changes in ADX direction, can signal potential trend reversals. Traders may use these signals to adjust their positions or consider new trading opportunities.
Limitations of ADX:
- Lagging Indicator: DX is a lagging indicator, meaning it reflects historical price action. Traders should use it in conjunction with other indicators for a more comprehensive analysis.
- Non-Trending Markets: In non-trending markets, ADX may provide false signals as it tends to produce low values. It is crucial to consider the overall market conditions.
- False Crossover signals: They occur frequently, sometimes too frequently, resulting in confusion and potentially lost money on trades that quickly go the other way and are more common when ADX values are below 25. That said, sometimes the ADX reaches above 25, but is only there temporarily and then reverses along with the price.
Conclusion:
The Average Directional Index is a powerful tool for traders seeking to understand and capitalize on market trends. By providing insights into trend strength and direction, the ADX helps traders make informed decisions and enhances their overall technical analysis toolkit. However, like any indicator, it is essential to use ADX in conjunction with other tools and consider the broader market context for more accurate and reliable trading signals.
