Trading with the Average Directional Index (ADX) Indicator
The average directional index or ADX indicator for short, as the name suggests is a directional index. In other words, the ADX belongs to a group of indicators that show the general direction of the markets.
This can also be called as a trend gauging indicator. The ADX indicator is not something new. It has been in existence for quite a while. The indicator was developed by Welles Wilder. The indicator was primarily designed to trade with the stock markets. It also goes by other names such as the directional movement index or the DMI.
Regardless of the different names or the markets that the ADX indicator was designed for, it can be applied to not just the stock markets but also futures and forex as well. Because prices, regardless of the markets tend to behave in the same way, the ADX finds its use in technical analysis.
If you are looking to gauge the strength of a trend, then the ADX indicator is the go-to indicator of choice for traders. Based on mathematical formulae, the ADX measures the trend strength. Traders can then use this information in order to ascertain when is a good time to enter into the trend.
As you might have noticed, the average directional index indicator is ideally used for trend following set ups. As a result, the ADX is best suited to trade on the long term trends. However, short term swing traders can also use the index and put it to use.
Typically, traders can gauge the trend of the index and then move to a smaller timeframe and trade based off the short term movements in the trends. This allows traders the benefit to pick the turning points in the short term trends, while training within the direction of the larger trends.
What is the difference between trend indicators and trend strength indicators?
When talking about trend indicators and trend strength indicators and comparing the both, traders will find some distinctive differences. For one, a trend indicator only measures the trend. Typically, traders use an indicator such as a moving average which forms the basis of the trend analysis.
General rules dictate that when price is trading above its average price, the markets are said to be in an uptrend. Likewise, when the price is trading below its average price, the markets are said to be in a downtrend.
While this is a good way to understand what the underlying trend in the market is, it does not show traders on the strength of the trend. There is no way to differentiate or forecast if the current trend will continue.
This is where a trend strength indicator comes into play. As the name suggests, a trend strength indicator such as the average directional index (ADX) indicator basically shows you the strength of the trend.
This brings with it some distinctive benefits. For one, you will be able to ascertain when the trend is weak and when it is strong. Price action across the markets tend to move in a zig-zag fashion. This means that trend strengths can rise and fall.
A weakness in the trend strength doesn’t necessarily mean that the trend will change. It could simply predict the direction in the change of the trend. Therefore, knowing the trend strength can bring some distinctive advantages for the trader if they want to trade in the direction of the trend.
Another benefit of the trend strength indicator is that it shows when the markets are ranging. But make no mistake in assuming that the trend strength indicator can forecast price trends.
As with most technical indicators built on price, the trend strength indicator is also a reactive indicator. In other words, the trend strength indicator tends to react to the price rather than the other way around.
You could therefore experience some lag. Still, the trend strength indicator is a good way to identify when the trend will strengthen and weaken.
The first chart below shows a comparison between the moving average and the average directional index (ADX) indicator.
Trend v/s Trend Strength indicator
You can see that while the moving average merely depicts whether the markets are in an uptrend or a downtrend, the ADX indicator on the other hand can reflect the rise and fall in the strength of the trends.
In the above chart, you can see that the rise and fall in prices to and from the 50-period exponential moving average coincides with the rise and fall in the trend strength as depicted by the ADX indicator.
Therefore, from the above, it should be evident of this primary difference between a trend indicator and the trend strength indicator.
Understanding how the Average directional index (ADX) indicator works
The average directional index (ADX) indicator as seen in the previous chart is an oscillator. It is displayed in the lower part of the chart. The indicator comprises of three lines. The three lines are known as:
1. The ADX line
The DI+, is usually depicted with a green color, while the DI- is depicted by the red color. These two lines measure the trend’s rise and fall. When the DI+ is above the DI- line, it indicates that the general trend is to the upside.
Conversely, when the DI- is above the DI+, it depicts that the general trend is to the downside. Thus, looking at the DI+ and the DI- lines, traders can understand what the trend is like.
But it doesn’t just help to see what the trend is like. The ADX is after a trend strength indicator. The strength of the trend is seen by the ADX line itself. When this line rises to the extreme, moving into an upward slope, it suggests that the underlying trend is strong.
The underlying trend can be positive (when DI+ is greater than DI-) or the underlying trend can be negative (when DI- is greater than DI+). The trend or the momentum starts to weaken as reflected by the downward slope of the ADX line itself.
A general level of 20 or 25 is selected as a level to measure when the momentum is rising or falling. Therefore, ideally, a strong uptrend is seen when DI+ is greater than DI- and the ADX line is above 20 or 25 level.
Similarly, a downtrend is said to be strong when the DI- is greater than the DI+ and the ADX line is above the 20 or 25 level.
The next chart below these examples.
ADX Trend Strengths
In the above chart you can see the areas marked by the vertical lines. Each of these columns depicts the different stages of the trends. Starting from the left, the markets are in a strong downtrend. This is evident from the fact that the ADX indicator showed a high level while the DI- was greater than the DI+ indicators.
Following this strong downtrend, you can then see that the ADX line was trading around the 20 region. This area marks the flat period when prices were trading flat. Following this period, the trend once again starts to rise.
In the subsequent uptrend that followed, the ADX indicator started to rise above 20 or 25 level. This indicates that the uptrend (where DI+ is greater than DI-) was strong. This phase and the initial phase are seen to be the strongest areas when both the markets were rising and falling.
The calculation of the ADX indicator is quite simple comparing to the way the trend strength is visually depicted.
The DI+ is calculated as the current high minus the previous high. When this is greater than the previous low minus the current low, the DI+ moves higher. When the value is negative, a zero is assigned.
The DI- is calculated as the current low minus the previous low. When this value is greater than the previous high minus the current high, the DI- index moves higher. A negative outcome is assigned a zero.
Thus, by comparing the highs and the lows and comparing it to the previous values, the DI- and the DI+ values are assigned. Both these values are then combined along with a smoothing factor to derive the ADX line itself.
It is interesting to note that the ADX line itself also draw upon the average true range. The average true range or the ATR indicator is itself another similar indicator that shows the average range of the prices.
The ATR basically measures the range and thus depicts how volatile the price of the security is.
The default setting for the ADX indicator is set to 14 periods when used on a daily chart. If you want to use the ADX indicator on smaller time frames, you might want to adjust the settings. As with any indicator, using a smaller value can lead to the indicator turning more sensitive while using a higher or a larger value can make it very lagging in nature.
Because no two markets have the same characteristics, traders need to carefully adjust the ADX indicator settings. Typically, a value of 7 or 14 is used depending on the time frame that you are using.
ow to use the Average directional index (ADX) indicator in trading?
As we mentioned earlier in the article, the ADX is basically a trend strength indicator. It shows the direction of the markets. Therefore, it makes sense to use the indicator as a way to ascertain the trend and the strength.
You will see that the ADX eliminates the need for having to use the moving average indicator as a trend indicator. However, you could still use it for trading purposes. Because prices tend to gravitate to and from the moving average, you can expect some reaction when this happens.
The ADX is ideally used to pick turning points in price. Therefore, it can be combined along with momentum indicators such as the Stochastics indicator. The difference here is that the Stochastics indicator can depict overbought and oversold conditions in the market.
But one question that it does not address is whether the overbought or oversold conditions will lead to a build up of momentum. In other words, there is no telling whether the turning points in price will lead to a sustained move.
This is where the ADX indicator can help. The next chart below shows a moving average, the ADX indicator and the Stochastics indicator on the chart. The moving average indicator is used as a trigger for the trades.
The Stochastics indicator is used to see when the market momentum is falling and whether or not the markets are in an overbought or oversold condition.
Finally, the ADX indicator will tell us when the trend is the strongest.
The ADX Trading Strategy
The area marked by the rectangular box shows the ideal conditions. Here, we see that the markets dipped a bit. This was reflected by the Stochastics indicator showing somewhat oversold conditions.
Following this, we see the Stochastics oscillator reversing from the oversold conditions. This tells us that the direction is changing. We know that the overall trend is up by comparing price to the moving average.
Lastly, we look to the Average directional index (ADX) indicator. You can see that the ADX line is above 20 suggesting that the uptrend is strong. Therefore, we can place a long entry on the pivot high prior to the small correction.
Stops are placed at the low and of course, target is placed to the open gap that was formed a few months ago. In the above case you can see that the ADX indicator was adept at signaling when to enter into the trend.
The trade quickly reaches the target before falling back. You can use the same approach when the markets are in a downtrend as well. Simply start by looking at price and comparing it to the moving average.
If price is below its moving average, then the markets are in a downtrend. Of course, you should also look at the ADX at this point to validate that the DI- is above the DI+. Next, watch the Stochastics oscillator to signal an overbought condition. This can typically occur when the price is posting a correction to the downtrend.
Once the overbought level condition is identified, you then wait for the Stochastics to move out from the overbought condition. Validate this view by looking for the ADX indicator to rise above 20 (ideally it should start to slope higher). Following this, you can then use your technical analysis skills and set the entry and the target and stop loss levels.
The ADX indicator is also a good indicator that can tell you when to stay out of the markets. Usually during this sideways period of consolidation, you can expect the ADX line to hover near the 20 level.
ADX indicator depicting sideways market
In the above chart, we have a current example of the gold market. You can see how prices have been very choppy. This is evident from the fact that the ADX line has been somewhat flat, trading close to the 20 level.
Based on this alone, you should be able to tell that the markets are in fact flat. If you look at the Stochastics oscillator on the other hand, you will see that the oscillator continues to move around the overbought and the oversold conditions. But it does not tell you whether the trend is strong or not.
ADX Indicator – Conclusion
In conclusion, the average directional index or the ADX indicator is a very simple but a powerful indicator that you can use. It will tell you the strength of the trend and helps you to avoid trading when the markets are moving in a sideways range.
Due to the fact that the ADX is a trend strength indicator, it is best suited to trade the long term trends. Some indicators that can complement the use of the ADX indicator include Bollinger bands, Donchian channels, Keltner channels and so on.
It is recommended that you use the average directional index (ADX) indicator alongside other technical indicators. But do not make the mistake of using redundant indicators which depict the same information.
For trend traders, it is essential to get the trade right. Timing is an important factor and this is where the ADX indicator can be put to good use. You can also use the ADX indicator with price action based technical analysis as well.
For example, you can validate the candlestick patterns in relation to a key support or resistance level. Then look to the ADX indicator to validate the trend and the potential strength. This can lead to better trade management and you will be able to cover your risks rather quickly into a trade.
The ADX indicator can be applied to any markets, but it is recommended that you pick markets where trends are maintained for a prolonged period of time. The ADX indicator can also be applied across any time frame of your choice, making this a versatile technical trading indicator that you can use.