Trend-following systems remain a popular way of trading, but not every breakout turns into a trend. Indeed, studies indicate that markets trend less than 30% of the time, with the rest of that being given over to range-bound trading that will frustrate those looking to take advantage of firm directional movement. The Average Directional Index (ADX) can help to reduce the number of possible trades, with the goal of narrowing down a list of trade ideas to provide potentially more profitable opportunities.
How to use this guide
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What is the Average Directional Index (ADX)?
The Average Directional Index (ADX) is a popular technical analysis tool and a widely used three-line indicator. It helps traders to find out if the market is trending and how strong this trend is. ADX may be applied to any trading instrument, including stocks, indices, cryptocurrencies, and forex.
The ADX Indicator commonly includes three separate lines. The ADX is usually accompanied by two other indicators – the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). These lines help traders decide whether to take a long or a short trade or hold back from making a trade at all.
To quantify the trend’s strength, the calculation of the Average Directional Index is based on a moving average of a price range expansion over a certain timeframe. Typically, the indicator is calculated for a 14-day period, although it may be implemented to any — including an hourly or weekly — chart.
The ADX indicator is available on the CAPEX.com platform. Our award-winning platform allows traders to customize technical indicators and tools, add drawing tools to price charts and graphs, and identify chart patterns in order to improve their trading strategy.
Who invented the ADX Indicator?
The Average Directional Index (ADX) was created in 1978 by J. Welles Wilder for analyzing commodity price charts but can be perfectly applied to any market and timeframes.
Born in the 1930s, J Welles Wilder was an engineer turned real estate developer, turned technical analyst.
Best known for his works on technical analysis, Mr. Wilder also created the Average True Range (ATR) and Parabolic SAR indicators.
How to use ADX
As mentioned above, the ADX indicator comes with 3 lines: the general ADX line (the black line in our examples) and the two DI lines (green and red lines). We will first look at the ADX line.
The ADX indicator line
Essentially, the ADX line measures trend strength, and a rising ADX means that the trend is gaining strength, a falling ADX shows a trend that is losing momentum or reversing and a flat ADX shows a sideways range.
What is also important to know is that the ADX is non-directional which means that it does not give any information about the direction of the trend. When the ADX goes up, all it means is that the trend is gaining strength – this can then signal both a bullish or bearish trend. The two screenshots below show this nicely and the ADX rises both during the uptrend (first screenshot) and during the downtrend (second screenshot).
Finally, we must talk about the threshold level of the ADX indicator. As you can see in the USA500 and US Tech 100 charts below, we plotted a vertical line at the ADX window at the 20.00 level. The 20.00 level acts as a tiebreaker: if the ADX is below the 20.00 level, the price is in a range or in a very weak trend and only when the ADX breaks above the 20.00 level, it signals a strong trend that is likely to continue. In the USA500 chart below we marked the first time the ADX breaks above the 20.00 level and then when the ADX broke back below the 20.00 level and signaled that the price has lost momentum.
The DI lines
The second part of the ADX indicator is the two DI lines which are usually color-coded (yellow and green in our example). The DI lines provide directional information, and they also measure trend strength.
When +DI (yellow) is above –DI (green), there is more upward pressure than downward pressure in the price. Conversely, if -DI is above +DI, then there is more downward pressure on the price.
The larger the spread between the two primary lines, the stronger the price trend. If +DI is way above -DI the price trend is strongly up. If -DI is way above +DI then the price trend is strongly down.
The DMI is primarily used to help assess trend direction and provide trade signals. Crossovers are the main trade signals.
The indicator can also be used as a trend or trade confirmation tool. If the +DI is well above -DI, the trend has strength on the upside, and this would help confirm current long trades or new long trade signals based on other entry methods. Conversely, if -DI is well above +DI, this confirms the strong downtrend or short positions.
The DI crossover signal
When the DI lines cross each other, they give a signal; when the green line crosses above the red line, it means that the highs and lows of the previous candles are both moving higher which confirms an uptrend. When the -DI line crosses above the green +DI line, it shows that over the past candles, the price has been moving down and the lows and highs are going lower.
Crossovers are the main trade signals. A long trade is taken when the +DI crosses above the -DI and an uptrend could be underway. Meanwhile, a sell signal occurs when the +DI instead crosses below the -DI. In such cases, a short trade may be initiated because a downtrend might be underway.
ADX calculation formula
Primarily used for defining a trend strength, or momentum, the indicator is calculated according to the Average Directional Index formula.
To calculate the ADX, you should first specify the positive (+) and negative (-) DM or directional movement. The +DM and –DM can be determined by calculating the “up-move” (current high minus the previous high) and the “down-move” (current low minus the previous low).
If the up-move is larger than the down-move and is more than zero, the positive directional movement or (+DM) equals the up-move. Otherwise, it equals zero.
If the down-move is larger than the up-move and is more than zero, the negative directional movement (-DM) equals the down-move. Otherwise, it equals zero.
The Positive Directional Indicator (+DI) equals 100 times the EMA (exponential moving average) of +DM divided by the ATR (average true range) for a set number of periods (usually for 14 days). The Negative Directional indicator (-DI) equals 100 times the EMA of –DM divided by the ATR.
The ADX indicator equals 100 times the EMA of the absolute value of (+DI minus –DI) divided by (+DI plus –DI).
How can you use ADX in trading
When you see the ADX signals and you want to place a trade, you can do so via derivatives such as CFDs. Derivatives enable you to trade rising as well as declining prices. So, depending on what you think will happen with the asset’s price when one of the ADX signals appears, you can open a long position or a short position.
Follow these steps to trade when you see the stochastic signals:
- Trading any type of technical indicator requires patience and the ability to wait for confirmation. The appearance of one of these ADX signals alerts traders of a price reversal, but until that occurs, most traders leave the pattern alone.
- To get started trading stochastic oscillators, open an account. Choose between a live account to trade CFDs straight away or practice first on our demo account with virtual funds.
- Choose your financial instrument. ADX signals can be spotted in most financial markets, especially those that are more volatile, such as forex, cryptocurrencies, and stocks.
- Explore our online trading platform. We offer a wide range of technical indicators that are not limited to ADX, as well as providing a range of order execution tools for fast trading, which in turn helps you to manage risk.
The below strategies for trading ADX signals are merely guidance and cannot be relied on for profit.
1. Trend Strength
At its most basic, the ADX indicator can be used to determine if a security is trending or not. This determination helps traders choose between a trend-following strategy or a non-trend-following system. A strong trend is present when ADX is above 20 and no trend is present when ADX is below 20. As noted above, chartists may need to adjust the settings to increase sensitivity and signals. ADX also has a fair amount of lag because of all the smoothing techniques. Many technical analysts use 20 as the key level for ADX.
The chart above shows two non-trending periods as the EURUSD formed as ADX moved below 20. A strong trend emerged as ADX moved above 20 and remained above 20.
ADX should be used in conjunction with other support/resistance indicators and trend patterns in order to identify a potential new trend at the bottom of the trading range.
2. Trend Direction and Crossovers
Here is a simple system for trading with these directional movement indicators. The first requirement is for the ADX indicator to be trading above 20. This ensures that prices are trending. A buy signal occurs when +DI crosses above -DI. Wilder based the initial stop on the low of the signal day. The signal remains in force if these low holds, even if +DI crosses back below -DI. Wait for this low to be penetrated before abandoning the signal. This bullish signal is reinforced if/when ADX turns up and the trend strengthens. Once the trend develops and becomes profitable, traders can incorporate a stop-loss and trailing stop should the trend continue. A sell signal triggers when -DI crosses above +DI. The high on the day of the sell signal becomes the initial stop-loss.
The chart above shows the three directional movement indicators. A lower setting means more possible signals. The buy signal appears when ADX moves above 20 with +DI above -DI. As with most such systems, there will be whipsaws, great signals, and bad signals. The key, as always, is to incorporate other aspects of technical analysis:
- support and resistance levels, including trendlines, Fibonacci retracements, Harmonic patterns, pivot points
- chart patterns, including western styles like double/triple top and bottoms or head and shoulders, and Japanese candle patterns like Doji or bullish/bearish engulfing
- other trading indicators, including Bollinger Bands, RSI, MACD, Ichimoku, or Stochastic
The exit signal appears when +DI moves below –DI.
The Bottom Line: Finding Friendly Trends
The best trades come from trading the strongest trends and avoiding range conditions. ADX not only identifies trending conditions but also helps the trader find the strongest trends to trade. The ability to quantify trend strength is a major edge for traders. ADX also identifies range conditions, so a trader won't get stuck trying to trend trade in sideways price action. In addition, it shows when the price has broken out of a range with sufficient strength to use trend-trading strategies. ADX also alerts the trader to changes in trend momentum, so risk management can be addressed. If you want the trend to be your friend, you'd better not let ADX become a stranger.
- ADX below 20: the market is currently not trending
- ADX crosses above 20: signify that a new trend is emerging. Traders may start seeking trade setups in the direction of the price movement.
- ADX between 20 and 40: When the ADX is growing between 20 and 40 it is considered as a confirmation of an emerging trend. Traders can use this signal to buy or short sell in the trend's direction if confirmed by DI crossover signals and other technical analysis tools.
- ADX above 40: the trend is very strong.
- ADX crosses 60: a very rare occasion, which is called a “Power Trend.”
Free trading tools and resources
Remember, you should have some trading experience and knowledge before you decide to trade with indicators. You should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader.
Our demo account is a great place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.