What is the ADX Indicator?

12 February 2021

    ADX stands for Average Directional Movement Index and it is an indicator that is a part of the Directional Movement System, introduced by Welles Wilder in his famous book - New Concepts in Technical Trading Systems. The ADX indicator is an indicator that measures purely the strength of the current trend, and it is considered one of the most important and reliable indicators. The ADX indicator does not indicate the direction of the trend, but rather the relative strength of the movement on both sides of the chart. It is very often used in combination with other indicators as a confirmation indicator for entry and exit signals. The ADX forex indicator is plotted on a range between 0-100 with the highest values denoting a stronger trend.

     

    ADX Indicator Calculation

     

    The ADX is a product of two other indicators composing the Directional Movement System - the positive directional indicator (abbreviated DI+) and negative directional indicator (DI+). The ADX is a smoothed moving average of the combined result of DI+ and DI-.

     

    To calculate DI+ and DI-, one needs price data consisting of high, low, and closing prices each period (typically each day). One first calculates the directional movement (DM- and DM+):

     

    UpMove = today's high − yesterday's high

    DownMove = yesterday's low − today's low

    if UpMove > DownMove and UpMove > 0, then DM+ = UpMove, else DM- = 0

    if DownMove > UpMove and DownMove > 0, then DM- = DownMove, else DM- = 0

     

    After selecting the number of periods (Wilder used 14 days originally), DI+ and DI- are:

     

    DI- = 100 times the smoothed moving average of (DM+) divided by average true range

    DI+ = 100 times the smoothed moving average of (DM-) divided by average true range

     

    The smoothed moving average is calculated over the number of periods selected, and the average true range is a smoothed average of the true ranges. Then:

     

    ADX = 100 x smoothed MA(ABS(DI+ − DI-)/(DI+ + DI-))

     

    The ADX values can be interpreted as follows

     

    0-25 Weak or no trend

    25-50 Strong trend

    50-75 Very strong trend

    75-100 Extremely strong trend

     

    Based on the above values of the ADX forex indicator and in combination with other signals, traders make the appropriate entry and exit decisions.

     

    ADX Indicator in Fondex cTrader

     

    ADX is a part of the Directional Movement system indicator and in cTrader it is displayed in conjunction with DI+ and DI- indicators. We can see an example of the Directional Movement System from Fondex cTrader below:

     

     

    To add the Directional Movement System in Fondex cTrader, right-click on the chart and navigate to Indicators > Trend > Directional Movement System. After clicking on Directional Movement System, the below form will appear.

     

     

    In this form you select the periods for the calculation of the ADX Indicator, customize your line’s color thickness and type and press OK. The Directional Movement System indicator will be added on your chart.

     

    ADX Indicator Strategies

     

    As discussed above, the ADX indicator informs the trader about the strength of the trend, but it does not give any indication of its direction. Therefore it needs to always be used in conjunction with other indicators to generate valid buy and sell signals. Below we present some of the most popular trading strategies using ADX.

     

    Directional Movement System Strategy

     

    The most common use of the ADX strategy is within the Directional Movement System, alongside DI+ and DI- indicators. While ADX measures the strength of the current trend, DI+ measures the bullish movements and DI- measures the bearish movements. The combination of these indicator readings might provide valid entry signals.

     

    A typical buy signal for the directional movement strategy is when the ADX value is above the threshold of 25, informing about a strong current trend, and DI+ crosses above DI-. The interpretation of this signal is that buyers are creating momentum, therefore it is a good time to enter a buy position. The opposite is true for sell signals. When the ADX value is above the threshold of 25 and DI+ crosses below DI-, then it is probably a good time to sell, since bears seem to take control of the market.

     

    Below we can see some examples of such buy and sell signals in Fondex cTrader. The red vertical line indicates the sell signal while the green vertical line indicates the buy signal.

     

     

     

    In the chart above, we can see two signals. The first signal is a sell signal and it occurs when the DI+ crosses below the DI- indicator. At that moment the ADX has a value well above 25, which means that the trend is really strong, so entering a sell position would be a good choice, assuming that there is a good chance the trend will not be terminated any time soon. Indeed, the downward movement continues for the next several bars, confirming the validity of the signal.  Later on we can see that there is a reversal in the price movement and soon afterwards a buy signal is generated, as the DI+ indicator crosses above DI- , while the ADX is still much higher than 25. The buy trend continues for a good amount of time after the signal has been generated, confirming the buy signal too.

     

    RSI & ADX Strategy

     

    Another popular strategy involving the ADX indicator is the combination with the RSI indicator. RSI indicator is used for identifying overbought and oversold conditions for a specific instrument. The basic rules for combining the two indicators in one strategy are the following

     

    1. ADX should be above 50. This means that the trend is very strong at the specific moment.
    2. When RSI closes below 30, enter a sell position. 
    3. When RSI closes above 70, enter a buy position.

     

    Even though the common use of the RSI is to identify overbought and oversold conditions in the quest of possible price reversals, in this case it is used as a confirmation signal of a strong trend that it is very likely to continue. Such signals are rare since the ADX rarely spends much time above 50 but when generated they can provide very strong signals. Below we can see an example of a buy signal taken from Fondex cTrader chart.

     

     

    We can notice how an ADX-RSI buying signal predicted that a slow buying trend in XRPUSD would be transformed into an upwards eruption of the price as it can be seen on the chart. In this case, the ADX-RSI signal proved to be a very accurate well-timed signal.

     

    Limitations of the ADX Indicator

     

    ADX Indicator, as any other technical indicator, always needs to be used in context. An out of context interpretation of ADX Indicator patterns can generate a lot of false signals that could lead to substantial losses. Therefore, when using the ADX Indicator, always consider the market fundamentals that currently move the market, and combine the signals with other confirmation signals, like trend indicators, support/resistance levels and the relevant price action taking place on the chart.

     


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#Educational#indicator#Indicator#ADX