ADX Indicator: Understanding the Average Directional Index

The ADX indicator has a unique history that sets it apart from other technical analysis tools. Created by J. Welles Wilder Jr. in the 1970s, the ADX was designed to measure the strength of trends in markets. Wilder believed that measuring the strength of a trend was more important than determining its direction, and the ADX was the first indicator to reflect this idea. The ADX quickly became popular among traders, and it remains a powerful tool for evaluating trend strength to this day. This indicator is a popular tool used by traders for technical analysis, to evaluate the strength of a trend. This indicator is used for many financial instruments, such as stocks, currencies, and commodities. In this article, we will delve into the workings of this powerful indicator, from its calculation to its interpretation and practical use.

ADX Calculation

The ADX indicator calculates the strength and direction of a trend in a financial instrument. The calculation is based on the price range expansion over a specific period, usually 14 periods. The first step in the calculation is to determine the true range, which is the largest of the following three values: the difference between the current high and low, the difference between the previous close and the current high, or the difference between the previous close and the current low.

Next, the directional movement is determined by taking the difference between the current high and the previous high, or the difference between the current low and the previous low. The directional movement is then divided by the true range to obtain the directional movement index (DMI). The DMI is used to calculate the positive directional index (+DI) and negative directional index (-DI), which measure the strength of the upward and downward movements, respectively.

The +DI and -DI are then used to calculate the ADX, which is a smoothed version of the DMI. The calculation steps for the ADX, +DI, and -DI are based on the Plus Directional Movement (+DM) and Minus Directional Movement (-DM) values calculated above, as well as the Average True Range (ATR), which reflects the true magnitude of the move.

To calculate the ADX, the true range, +DM, and -DM are first smoothed using Wilder’s smoothing techniques. The 14-day smoothed +DM is then divided by the 14-day smoothed true range to find the 14-day +DI, which is multiplied by 100 to move the decimal point two places. This +DI is the green line plotted along with the ADX line. Similarly, the 14-day smoothed -DM is divided by the 14-day smoothed true range to find the 14-day -DI, which is multiplied by 100 to move the decimal point two places. This -DI is the red line plotted along with the ADX line.

The Directional Movement Index (DX) is calculated by taking the absolute value of +DI14 less -DI14 divided by the sum of +DI14 and -DI14 and multiplying the result by 100 to move the decimal point over two places. The first ADX value is simply a 14-day average of DX. Subsequent ADX values are smoothed by multiplying the previous 14-day ADX value by 13, adding the most recent DX value, and dividing this total by 14. This process is repeated for each period to calculate the ADX value.

ADX Interpretation

The ADX indicator is used to determine the strength of a trend and whether a trend is reversing. An ADX reading of 25 or higher indicates a strong trend, while an ADX reading of 20 or lower indicates a weak trend. A rising ADX indicates that the trend is gaining strength, while a falling ADX indicates that the trend is losing strength.

In addition to determining the strength of the trend, the ADX can also be used to gauge volatility. When the ADX is low, it may indicate that the market is consolidating, while a high ADX value may indicate that the market is volatile.

Divergence also happens when the price of an asset and the ADX indicator move in different directions. Divergence can be a powerful signal that a trend is about to reverse. Divergence signals are important for traders to pay attention to because they can be a good time to enter or leave a position.

The ADX on a Chart

When analyzing a chart, the ADX indicator is typically displayed in a separate window below or above the main chart window that shows the price. The ADX line ranges from 0 to 100 and represents the strength of the trend, rather than the direction of the trend. A high ADX value indicates a strong trend, regardless of whether it is an uptrend or a downtrend.

Some versions of the ADX indicator also show the +DMI and -DMI lines, which are used to determine trend direction. However, many technical analysts prefer to only view the ADX line, as the three lines can be visually confusing, and the crossovers of the +DMI and -DMI lines often generate false signals. Therefore, the ADX indicator is generally considered to be more reliable as a trend strength indicator than a trend direction indicator.

Source: https://school.stockcharts.com/

Using the ADX Indicator

The ADX indicator is used to determine whether a market is trending at all and to determine the strength of a trend in a trending market. It is also often used to indicate a potential market reversal or trend change. Traders can use the ADX in combination with other technical indicators to gain a better understanding of the price action and to improve their trading decisions.

When the ADX value is below 25, the market is considered to be ranging rather than trending. Some analysts peg only ADX readings below 20 as indicative of the absence of a trend, and readings between 20 and 25 as possible, but not conclusively, indicating the presence of a trend. Any ADX reading above 25 is interpreted as indicating the existence of a genuine trend. Readings between 25 and 50 indicate a beginning or moderate strength trend, while readings between 50 and 100 represent increasingly strong trends.

The direction of trend strength - increasingly or decreasingly strong - can easily be determined by looking at the slope of the ADX line. An upsloping ADX line shows a strengthening trend, while a downsloping ADX line indicates a weakening trend. A steeper angle of slope indicates a stronger trend, while a shallower angle indicates a trend with less strength.

Source: https://school.stockcharts.com/

It is important to note that a change in the direction of the ADX slope can serve as an early indicator of a developing trend even before ADX readings go above 25. However, it is essential to remember that the ADX line might just as easily have turned back to the downside before a genuine uptrend became established. Therefore, traders should not base their trading decisions solely on the ADX indicator and should use other technical analysis tools to confirm their entry or exit points.

When using the ADX indicator, it is rarely used alone and is typically used in conjunction with other trend indicators, such as moving averages or support and resistance areas, which are used to analyze price movement. For example, an ideal application of using trend indicators in combination with the ADX would be an instance where the price of a security has traded within a range with clearly defined support and resistance price levels but then breaks out of that trading range by trading through a support or resistance level. If the price breakout is accompanied by rising ADX readings that indicate the presence of a trend, then that would constitute a confirming indication of the validity of the breakout, and an analyst would project a trend continuing in the direction of the breakout.

Conclusion

In conclusion, the Average Directional Index (ADX) is a technical analysis tool used by traders to evaluate the strength of a trend in financial markets. Developed by J. Welles Wilder Jr. in the 1970s, the ADX is calculated based on the price range expansion over a specific period, usually 14 periods. A high ADX value indicates a strong trend, while a low ADX value suggests a weak trend or a market consolidation. The ADX can also be used to gauge volatility and determine trend reversals. However, the ADX should not be used in isolation, but in combination with other technical indicators to confirm entry or exit points. The ADX remains a powerful tool for evaluating trend strength, and it is widely used by traders for technical analysis of various financial instruments, including cryptocurrencies.