The Average Directional Index (ADX) is a popular technical indicator that traders often rely on to measure the strength of a trend. Whether you're trading stocks, commodities, or forex, understanding the ADX can be a valuable addition to your trading strategy, especially when you're focused on positional trading.
The ADX was introduced by J. Welles Wilder Jr. in his 1978 book, New Concepts in Technical Trading Systems. This indicator is a crucial part of the Directional Movement System (DMS), which helps traders identify the direction and strength of a trend. Unlike other indicators that primarily focus on price direction, the ADX is unique because it measures the strength of a trend, regardless of whether the market is moving up or down.
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The ADX is composed of three lines
The ADX Line:
This line measures the strength of the trend. A rising ADX indicates that the trend is gaining strength, while a falling ADX suggests that the trend is weakening, but it does not predict the direction of price movement or a reversal.
Plus Directional Indicator (+DI):
This line reflects the strength of upward movement.
Minus Directional Indicator (-DI):
This line shows the strength of the downward movement.
ADX Calculation
The ADX indicator has 3 lines: +DI (green line), -DI (red line), and ADX (white line). These lines are calculated using the formulas below:
+DI = ((Smoothed MA + DM)/ATR) * 100
-DI = ((Smoothed MA – DM)/ATR) * 100
DX = ((+DI – -DI)/(+DI + -DI)) * 100
First ADX = sum n periods of DX / n
After that, ADX = ((Prior ADX * n-1) + Current DX) /n
Where:
+DM = Current High – Previous High
-DM = Previous Low – Current Low
ATR = Average True Range
N = Number of periods used in the calculation (the default is usually 14 but traders can adjust this according to their needs).
The above calculation will plot the three lines of the ADX indicator. The +DI (green line) will be the positive directional indicator, whereas the –DI (red line) will be the negative directional indicator. The ADX (black line) is a non-directional indicator (essentially the average difference between +DI and –DI) and is plotted from 0 to 100, with no negative values.
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How to Read ADX Indicator
As mentioned above, the ADX line is primarily a momentum indicator. Based on this, a rising ADX implies a strengthening trend, whereas a falling ADX implies a weakening trend. Welles provided the ADX trend strength scale as below: Trend direction is determined by watching the +DI and -DI lines. An uptrend is in place when the +DI is above the -DI, whereas a downtrend is in place when the -DI is above the +DI. When +DI and -DI cross, it indicates that a trend reversal is occurring. The trend turns bullish if +DI crosses above -DI; similarly, the trend turns bearish if -DI crosses above +DI. It will be a case of a powerful trend if a cross occurs when the ADX line is also going up.
Understanding ADX and DI
| Feature | ADX | DI |
|---|---|---|
| Purpose | Measures the strength of a trend | Measures the direction of the trend |
| Calculation Basis | Derived from the smoothed difference between +DI and -DI | Calculated from directional movements: +DI for upward movement, -DI for downward movement. |
| Value Range | 0 to 100 | 0 to 100 |
| Indication | Higher values indicate a stronger trend; values below 20–25 suggest a weak or non-trending market. | +DI > -DI indicates bullish trend; -DI > +DI indicates bearish trend. |
| Trend Direction | It does not indicate the direction, only the strength. | Indicates the direction of the trend. |
| Common Thresholds | Above 25 is often considered indicative of a strong trend. | N/A: Relative positioning between +DI and -DI is what matters. |
| Use in Trading | It helps determine when to use trend-following strategies vs. range-bound strategies. | Used to confirm the direction of the trend and potential entry/exit points. |
| Smoothing | Smoothed using a moving average over a set period (typically 14 days) | No smoothing is applied directly; part of the overall ADX calculation process. |
| Practical Application | Useful for identifying the overall market conditions and adjusting trading strategies accordingly. | Helps in identifying potential entry and exit points based on trend direction. |
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Trading ADX Signals
The ADX delivers several price signals that can be traded in the market and learning how to trade these signals could enhance your trading accuracy. These signals include:
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 above 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.
Finding Ranges
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 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.
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 leave traders trapped in a bad trade position. The ADX helps 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.
Kisses
The ‘Kisses’ signal occurs when the +DI and -DI lines touch each other but then immediately resume their prior direction without crossing over. This often signals a pullback in a trending market, providing an opportunity to enter the market in the direction of the prevailing trend. For instance, if +DI is above -DI (indicating an uptrend) and the lines touch before +DI continues to move upward, this "kiss" can be a strong signal to add to or initiate a long position. Conversely, if -DI is above +DI (indicating a downtrend) and the lines touch before -DI continues downward, it can be a signal to enter or add to a short position.
Conclusion
The Average Directional Index (ADX) is a powerful tool that can significantly enhance a trader's ability to identify and capitalize on market trends. By focusing on the strength of trends rather than their direction, ADX provides a unique perspective that helps traders distinguish between trending and ranging markets, which is crucial for applying the right trading strategies. Whether it's through crossovers, identifying ranges, validating breakouts, or spotting pullbacks with the ‘Kisses’ signal, the ADX equips traders with actionable insights that can improve decision-making and trading performance.
However, like any technical indicator, ADX should not be used in isolation. Its true power lies in being part of a broader trading strategy, combined with other indicators and solid risk management practices. By understanding how to interpret ADX readings and applying them in real-time, traders can navigate market sentiments with greater confidence and precision, ultimately leading to more consistent and profitable trading outcomes. At TradeJini, we provide the tools and resources you need to stay informed about stock markets and make the most out of your trading journey.
