ADX: Find the Strong Trend
In a wide variety of indicators that provide different signals, it’s almost impossible to find the one that defines the strength of the trend. It’s vital to know whether the trend is stable or not, especially during the peak timeframes, when the trend exists from several days to several months. What if you see a trend and want to open a position but have no idea how soon the trend will end? Mr. Wilder invented the ADX indicator specifically for these cases.
What Is the ADX Indicator?
ADX stands for Average Directional Index. It’s a technical indicator that is mostly used to determine the strength of the trend. At the same time, it can be applied to find trends and ranges and to filter trading strategies. Usually, the indicator consists of a single line that fluctuates within the 0-100 range.
However, sometimes you can see the indicator of three lines: ADX, +ID, and –ID. Two additional lines are a positive directional indicator and a negative directional indicator. These lines serve to provide the direction of the trend. It’s unlikely you meet them separately from the ADX. Moreover, the average directional index is derived from them.
The indicator was invented by the technical trader J. Welles Wilder. He described the average directional index together with the minus directional indicator (-DI) and the plus directional indicator (+DI) in his book “New Concepts in Technical Trading Systems” in 1978.
This index has been around for many years. This proves that ADX can stand the test of time and provide valuable information. Have a look at the picture.
Why ADX Is So Popular
The ADX indicator is almost the only existing indicator that shows the strength of the trend. Even though other indicators also provide signals that show close reversal or possible breakouts, the average directional movement index gives more accurate signals.
Additionally, you can use this indicator not only for trading in the Forex market, but for trading stocks, futures, and even mutual funds.
The calculation may seem a little bit complicated. Don’t worry, you don’t have to calculate the index every time you use it – it is measured automatically. The ADX formula will just help you understand how the indicator works.
The calculation starts with measuring positive and negative directional movement.
+DM = Current High - Previous High
-DM = Previous Low - Current Low
There is an exciting feature. If +DM is bigger than –DM, then –DM equals 0. If –DM is greater than +DM, +DM is 0.
As we’ve mentioned earlier, the index is derived from +DI and -DI. The positive directional indicator (+DI) amounts to 100 times the exponential moving average (EMA) of +DM divided by the ATR (average true range) over a given period of time.
14 is the standard period. The negative directional indicator (-DI) is equal to 100 times the EMA of -DM divided by the ATR.
As for the average directional index, it is equal to 100 times the EMA of the absolute value of (+DI minus -DI) divided by (+DI plus -DI).
Strong Signals From ADX
There is a common misconception that the indicator shows the trend direction. The indicator shows only the strength of that trend. If you want to get the direction, you need to use ADX together with the -DI and +DI. There is a drawback of ADX not always being accompanied by these two lines depending on the trading platform you use. To provide you with full information, we will tell you both about the single ADX and ADX with two directional movement indicator lines.
If the indicator is below 25, the market moves sideways. If the index is above 25, the market forms a new trend, and the strength depends on the levels the indicator crosses.
|ADX Value||Trend Strength|
|0-25||Absent or Weak Trend|
|50-75||Very Strong Trend|
|75-100||Extremely Strong Trend|
ADX reflects the trend's momentum. If the indicator forms a series of higher highs, that means the trend is gaining momentum (becomes stronger). If ADX forms a series of lower peaks, the trend momentum is shortening. However, even if the peaks become smaller, but the indicator is still above 25, it doesn’t mean the trend changes. It just means it’s losing momentum.
Why do you need this information? When you know the momentum of the trend is rising, you get more confidence in keeping your position. At the same time, when you see the indicator signals the weakness of the momentum, but the trend still interacts, it’s a sign to manage the risk.
Here, we can apply another strategy. If the indicator forms a divergence with the price chart, you should consider managing your risks. When the price creates a higher high, but the index doesn’t follow it, forming a lower high, this is divergence. If you’ve heard something about RSI or MACD indicators, you know that usually, the divergence signals a market reversal. Here, the signal is not that strong. The index gives a sign the trend is weakening. However, the weakness may end up with consolidation, reversal, and trend continuation.
Breakouts happen in the market too often. It’s common if the breakout fails to develop and becomes a trap for traders. It’s essential to have an indicator that will either confirm or disprove them. The rule is simple – if the index rises in the range from 0 to 25, the price is strong enough to keep moving in the direction of the breakout.
It’s vital to know when the trend transforms into the range. To learn that, follow the ADX. When it falls from the area above 25 to the zone below 25, it indicates a range. Until the index is in the bottom zone, there is no trend. As soon as it rises, the price starts moving according to the trend.
ADX and Two Directional-Movement Indicator Lines
As we stated above, the indicator is often followed by two lines that help define the course of the trend. The signals are quite simple.
- When +DI is higher than -DI, it’s a bullish trend.
- If –DI is greater than +DI, the trend is bearish.
- Buy when +DI breaks above –DI. ADX should be above 25.
- Sell when -DI rises above +DI. ADX should be above 25.
How to Use ADX
The ADX is one of the fundamental indicators that is usually implemented into any trading platform. The only difference is that some platforms, for example, MetaTrader, provide the indicator with three lines. While others have an indicator with only one line.
To apply the indicator to the chart, you need to find it in the list of indicators. As for the settings, a 14 period is the standard number. However, you can apply another one regarding your trading strategy.
Common Mistakes with ADX
The indicator measures the strength of the trend, not its direction, as many other indicators do. It’s the most common mistake of a beginner trader. When you look at the index, you may associate it with Stochastic as it looks similar. The key levels are used to show how strong the trend is, not whether it’s bearish or bullish.
Another mistake is the wrong signal reading. Newbies think that the fall of the indicator signals the trend reversal. However, it just indicates the trend is weakening. Unless the indicator crosses the 25 line, it’s better to think that the trend is less strong.
Every trader is eager to catch the signal to enter the market at a perfect level. However, not every sign is correct. If you use the full system with ADX and directional indicator lines, it’s easy to be confused. +DI and –DI are entwined frequently. Thus, traders get false signals. To avoid this, you need to compare signals provided by different indicators or candles.
The Best ADX Trading Strategy
It’s up to you to find the perfect settings for the indicator and include it in your trading strategy. However, we would like to share the one strategy that can help you get some money.
Choose an asset you would like to trade and any timeframe that you are more familiar with. Apply the ADX and RSI indicators with standard settings to the chart.
Before we determine whether the trend is bearish or bullish, we need the average directional index to be above 25. As you might already know, it signals a strong trend.
To determine the trend, it’s enough to look at the last 10 candlesticks. If the price is moving lower in the previous 10 candlesticks, it’s a bearish trend. If the price is moving up within the last 10 candlesticks, it’s a bullish trend. However, the number of candles depends on the timeframe. The higher the timeframe is, the more candlesticks there should be.
Follow the RSI indicator. We are going to trade within the downtrend. Wait for the RSI indicator to cross level 30. As soon as the index is below the 30 level, open a sell position.
If you’ve heard about the RSI indicator, you can be a little bit confused. According to the standard rules, readings below 30 are a sign of an upcoming reversal up as the market is oversold. However, it’s essential to use the indicators correctly.
In the strong trend, the RSI indicator can fluctuate in either oversold or overbought zone for an extended period. Thus, we need the ADX to signal a strong trend.
It’s time to define a stop loss that will neither throw you out of the market nor allow you to lose a lot. To find the perfect stop loss, you need to find the level where the ADX formed the last high before your entry. Correspond this top to the price chart, and you will get the level of the stop loss.
In the beginning, we were looking for a strong trend. It is the most crucial part of our strategy. That’s why we will take the profit based on the trend strength. As soon as the trend fades, we should be ready to close the trade. Wait for the ADX to cross the 25 upside-down and close your position.
The strategy can be easily used in the bullish trend. All you need to do is to use each step inversely.
It seems we have explained everything. However, you might still have so questions, so let’s try to get to the bottom of it.
Which Indicator Works Best With ADX?
The first indicator is the RSI. You shouldn’t be surprised as one of the best trading strategies combines signals of ADX and RSI. Although the RSI indicator is an oscillator and the ADX is a trend indicator, they work well together. Every trader knows that it’s easier to trade within the trend, not with sideways market. So, the RSI may provide reliable entry points, while the ADX is used to give signals on the trend power.
Also, you can use the index together with other trend indicators, for example, Parabolic SAR. It’s worth choosing the ones that are not based on Moving Averages. If you haven’t forgotten, the ADX calculation includes the Exponential Moving Average.
Is the ADX a Leading or Lagging Indicator?
The average directional index is based on the exponential moving average. All moving averages lag in time. Thus, it is the lagging indicator, but it’s the only limitation it has. The ADX confirms the trend only after it’s formed, and it’s impossible to predict the strength of something that does not yet exist.
The ADX indicator can be considered an exceptional indicator. It’s nearly the only indicator that provides a trader with information on the trend strength. We all remember the phrase: the trend is your friend. However, it’s not that easy to find a strong trend. As a result, you might lose money in times of breakouts and fake-outs, trend reversals, and market consolidation. To learn the indicator faster, check its signal in the Libertex demo account.
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