ADX (Average Directional Index) Definition and Strategy

For forex and stock market traders, understanding the direction and strength of a trend is a key component in building a successful strategy. This is where one of the technical analysis tools, the ADX (Average Directional Index), comes into play.

The ADX stands out from other indicators because it specifically measures the strength of a trend. Knowing whether a trend is strong or weak helps investors make more confident decisions and identify the right entry and exit points in the market.

The ADX indicator not only identifies whether there is a trend but also helps determine if the market is moving sideways or in a directional trend. Opening positions in a strong trend is generally more advantageous, while trading during weak trends tends to be riskier.

What Is the Average Directional Index (ADX)?

The Average Directional Index (ADX) is a technical analysis indicator used to measure the strength of a trend. It does not indicate whether an asset is in an uptrend or downtrend but shows how strong the current trend is. The ADX was developed by J. Welles Wilder in 1978. Since then, it has become particularly popular among trend-following traders.

• The higher the ADX value, the stronger the trend is considered to be.
• A low ADX value indicates that the market is in a sideways or weak trend.

ADX is usually used in combination with the +DI (Positive Directional Indicator) and -DI (Negative Directional Indicator). While these two additional indicators help determine the direction of the trend, the ADX measures the strength of the trend. This way, traders can understand both the direction in which the market is moving and how strong that movement is.

Calculating the Average Directional Index (ADX Formula) 

The calculation of the ADX requires considering the price changes between the high and low levels of a financial instrument. The core components of this process are +DI (Positive Directional Indicator), -DI (Negative Directional Indicator), and True Range (TR).

Let's start by calculating the True Range (TR). TR is determined by selecting the largest value among the following three calculations:

• The day's high price minus the day's low price
• The day's high price minus the previous day's close price
• The day's low price minus the previous day's close price

The formula for TR is as follows:

TR = max( H – L, |H – Cprev|, |L-Cprev|)

After calculating the TR, the +DM (Positive Directional Movement) and -DM (Negative Directional Movement) values must be calculated. These values measure how much the prices have moved up or down compared to the previous days:

• If the day's high price is higher than the previous day's high price, +DM is calculated.
• If the day's low price is lower than the previous day's low price, -DM is calculated.

The formulas are as follows:

+DM = Htoday – Hprev

-DM = Lprev – Ltoday

Next, the directional movement indicators +DI and -DI are calculated. These values express the directional price movements as percentages. They are calculated by dividing the positive and negative directional movements by the True Range (TR) and then multiplying by 100 to express them as percentages.

The formulas are as follows:

+DI = (+DM/TR) x 100

-DI = (-DM/TR) x 100

After this, the Directional Index (DX) is calculated. The DX value is obtained by dividing the difference between +DI and -DI by their sum and then multiplying by 100.

The formula is as follows:

DX = (|+DI – –DI| +DI + –DI) x 100

Finally, the ADX value can be calculated. The ADX value is derived by taking the exponential moving average (EMA) of the DX values over a specific period, typically 14 days.

The ADX formula is: ADX = EMA(DX, 14)

What Does the ADX Tell You?

The Average Directional Index (ADX) is an essential technical analysis indicator used to measure the strength of a trend in the market. However, ADX does not indicate the direction of the trend but rather shows how strong or weak the existing trend is. It is highly useful in trend-following strategies and helps traders determine whether the market is trending or moving sideways.

• A high ADX value indicates that the market is in a strong trend, making trading opportunities more reliable.
• On the other hand, a low ADX value suggests that the market is in a sideways or weak trend, indicating that trading in such conditions could be riskier.
• Particularly, ADX values below 20 signal to traders that the market lacks a clear trend, and they should be cautious when making trading decisions.

How to Use ADX? Example Using ADX

In the above chart, we can see the 30-day price movements of a stock and the corresponding ADX values during this period. The upper part of the chart shows price movements with a blue line, while the lower part displays ADX values with a red line. The green dashed line marks the 25 level of the ADX indicator.

Now, let's start interpreting the chart:

• Days 1-10: During this period, the price rises gradually, and the ADX value also increases. This indicates that the market is in a trending phase and the trend is gaining strength. When the ADX value exceeds the 25 level, the trend is considered strong, and traders may evaluate taking long positions.
• Days 11-20: The ADX value rises above 30, indicating a strong trend. During this period, price movements are upward, and traders can take advantage of this trend by maintaining their positions.
• Days 21-30: The ADX value starts to decrease and falls below the 25 level. This suggests that the trend is weakening, and the market might enter a sideways phase. In this case, traders should be cautious and review their current positions.

Using ADX and DMI Indicators Together

While ADX (Average Directional Index) measures the strength of a trend, DMI (Directional Movement Index) identifies the direction of the trend. This combination is particularly effective in trend-following strategies. It helps to filter out false signals and build a more reliable trading plan.

The DMI indicator consists of two lines: +DI (Positive Directional Indicator) and -DI (Negative Directional Indicator). The +DI line indicates an upward trend in the market, while the -DI line signals a downward trend. ADX, on the other hand, measures the strength of the identified trend. By analyzing the intersections of the +DI and -DI lines and the ADX value, traders can gather important insights about the market trend.

Here’s how to interpret the ADX and DMI indicators together:

• If the +DI line crosses above the -DI line and the ADX is above 25, this indicates a strong upward trend, and traders can consider taking long positions.
• If the -DI line crosses above the +DI line and the ADX is above 25, this indicates a strong downward trend, suggesting that short positions could be beneficial.
• If the ADX is below 20, the market is considered non-trending or range-bound, which means it may not be the best time for trend-following strategies.

Advantages of ADX

• Measures the strength of the trend to indicate whether the market is directional or not.
• Can be used to analyze both upward and downward trends.
• Helps determine whether the market is ranging or trending.
• Provides stronger signals when used in combination with other indicators.
• Assists trend-following traders in identifying accurate entry and exit points.
• Filters out false signals to reduce trading risks.
• Delivers effective results across different timeframes.
• Helps detect if the market is in a strong trend early on.
• Assists traders in avoiding trades during ranging markets.

Limitations of ADX

• ADX only shows the strength of the trend, not its direction.
• May produce false signals in sideways markets.
• It can react late to price changes.
• ADX can be misleading when used alone.
• It is not always suitable for short-term trades.
• Optimizing its settings can take time.
• It may respond with a delay to sudden price movements.
• ADX needs to be supported by other indicators.
• Its performance may vary under different market conditions.
• It may overlook small price fluctuations.

Aroon Indicator vs ADX Indicator

The Aroon indicator measures whether an asset is entering an upward or downward trend and the strength of that trend. It consists of two lines: Aroon Up and Aroon Down.

• Aroon Up measures how long it has been since the asset reached its highest price within a specific period. A high Aroon Up value indicates an upward trend.
• Aroon Down measures how long it has been since the asset reached its lowest price within a specific period. A high Aroon Down value indicates a downward trend.

The Aroon indicator is more suitable for early trend detection and can identify trend reversal points more quickly. On the other hand, the ADX is more effective in understanding the strength of an existing trend and provides more reliable results in long-term analysis.

Below is a table comparing the Aroon and ADX indicators based on different features:

More About ADX

What Is a Good Average Directional Index?

An ADX value of 25+ signals a strong trend, while below 20 indicates a weak or directionless market. Values between 20-40 show a forming trend, and above 40 reflect a strengthening trend with trading opportunities. Traders view ADX above 25 as a reliable indicator of a solid trend.

What Is the Best Indicator to Use With ADX?

Although the ADX indicator measures the strength of a trend, it does not indicate the direction of the trend. Therefore, it is more effective when used alongside other indicators. For example, the RSI indicator can be used with ADX to identify whether the market is in overbought or oversold conditions. The MACD indicator helps analyze both the direction and momentum of a trend, providing stronger signals when combined with ADX. Additionally, Bollinger Bands and the Parabolic SAR can be used with ADX to offer more accurate market analysis. 

How do you set up the ADX indicator?

To set up the ADX indicator, open your trading platform, such as MetaTrader, where ADX is built-in. Select the ADX from the technical indicators section, typically set to a 14-period calculation, but adjustable if needed. Ensure the +DI and -DI lines are displayed, and customize their colors for clarity. Once added, analyze the trend's strength and direction.