The Average Directional Index (ADX) is a three-line indicator that includes the ADX line, Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI). The indicator was developed by Welles Wilder--who also developed the Average True Range and Parabolic SAR among other indicators--and it helps traders determine if a stock or other asset is trending, and how strongly it is trending. Before using the indicator traders should understand how the indicator works, its uses for trading, and its limitations.
What Is the Average Directional Index (ADX)?
The indicator uses three lines to tell both the trend direction and the trend strength. When the +DI is above the -DI, buying is stronger than selling. When -DI is above the +DI, selling is stronger than buying.
The ADX line helps determine the strength of the trend. An ADX reading above 20 (some traders use 25) indicates a trend is present and attention should be paid to the +DI and -DI to determine the direction of the trend (see above). When ADX is below 20 a trend likely isn’t present, and therefore trend traders may wish to avoid trades in the asset.
The indicator is typically calculated over 14 days, although the indicator can be used on any chart, such as a 1-minute, hourly or weekly chart. A longer period than 14 days can be used by longer-term traders to produce less trade signals.
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The indicator has three lines, and each one must be calculated. The indicator is also based on True Range and Average True Range calculations – other indicators developed by Welles Wilder.
- Calculate the True Range for what will eventually be our +DI and -DI lines. True range is the greatest of the following: Current High minus current Low; Current High minus previous Close (absolute value); Current Low minus previous Close (absolute value).
- These values then need to be “smoothed,” typically over 14 days. Smoothing is discussed below.
- Divide the smoothed +DI by the 14-day smoothed True Range to find the 14-day +DI value, which will be used as the line on the chart. Multiply by 100.
- Divide the smoothed -DI by the 14-day smoothed True Range to find the 14-day -DI value, which will be used as the line on the chart. Multiply by 100.
- The Directional Movement (DX) equals the absolute value of +DI minus -DI divided by the sum of +DI and – DI.
- Average Directional Index (ADX) is a 14-day average of DX. All following ADX values are smoothed by multiplying the previous 14-day ADX value by 13, then adding the most recent DX value and dividing this total by 14.
To get the smoothed +DI and -DI values, use the following steps for each:
- Sum 14 True Ranges to get TR14
- Smooth it: TR14 – (TR14/14) + Current TR
- For following calculations: Prior TR14 – (Prior TR14/14) + Current TR14
To get the ADX values, use the following steps:
- ADX14 = 14 period Average of DX
- Following ADX values = ((ADX14 x 13) + Current DX Value)/14
Thankfully, the ADX is available on most trading platforms—so calculating by hand isn’t required—such as ThinkorSwim, and a number of free online charting sites including FreeStockCharts.com and StockCharts.com.
How ADX Is Useful
ADX can be used as part of a trading system that includes entry and exit signals, as well as for analytical insight.
When the +DI crosses above the -DI, initiate a long position. Since this type of signal is prone to “whipsaws” (when the multiple signals occur in quick succession) only take the signals that occur in the direction of the overall trend. A 50 or 100 period moving average can help determine the overall trend direction. As long as the price is above the moving average, initiate a trade when the +DI crosses above the -DI [see also Ultimate Guide to the Stochastic Oscillator].
Once a long trade is initiated, place a stop loss order below a recent low, like what is shown in Figure 2. Since the strategy centers around entering during a trend, and trends can persist for a long time, there is no specific profit target provided by the indicator.
When the -DI crosses above the +DI, initiate a short position (or also exit long positions). Only take new trade signals when they occur in the direction of the overall trend. A 50 or 100 period moving average can help determine the overall trend direction. As long as the price is below the moving average, initiate a short trade when the -DI crosses above the +DI.
Once a long trade is initiated, place a stop above a recent high, like what is shown in Figure 2. Since the strategy centers around entering during a trend, and trends can persist for a long time, there is no specific profit target provided by the indicator.
Beyond the crossover trading strategy, the ADX, +DI and -DI lines can help analyze a market.
Figure 4 shows an overall uptrend, as the price is making higher highs and higher lows and is also above a longer-term moving average. The ADX can help analyze this trend as it is occurring.
Working from left to right, the price is staying above the moving average, indicating the overall uptrend. When the +DI and -DI are close together it indicates a consolidation or pullback is occurring within the overall trend.
Over the course of the seven months, the ADX is continually making progress higher, moving from near 20 in January to over 40 in July. This shows the trend has been continually strengthening. This is due to how far +DI is above -DI; the large separation between the lines shows very strong upward momentum.
In July, +DI and -DI converge once again, indicating a consolidation or pullback in the overall uptrend. Looking up to the price, this is confirmed, as the price has been moving with more of a sideways trajectory in the July.
+DI and -DI lines crossover signals are prone to “whipsaws.” This is when the lines cross back and forth over each other in a short amount of time, generating multiple trade signals and likely resulting in losses. This is remedied by only taking trade signals in the direction of the larger trend (as discussed above). A trend line or moving average helps establish this longer-term trend.
The value of 20 or 25 may also not be ideal for isolating a trending market. The ADX may move above 25 only to fall back below it, for example. Just because the indicator moves above 20 or 25 doesn’t mean that trend will persist. It is also possible that a trend is in effect when the ADX is below 20; the trend is just not moving quickly.
Since it is an average, it can also be slow to react to trend changes. Like a moving average, it will always be lagging behind price. During a strong trend this can help keep traders stay in the trade, but the downside is that it will also typically get them in and out later than an indicator that is less “smoothed.”
The indicator does not provide a profit target. While that means the profit potential on trades is open ended, leaving room for big gains, it also means a lot of profit can be given back before a reversal signal is generated by the indicator. Therefore it is recommended that some profit taking strategy is implemented (see: 3 Ways to Exit a Profitable Trade).
The ADX indicator is a combination of three lines – ADX, -DI and +DI. When +DI is above -DI, it means buying is stronger than selling. When ADX is above 20 (or 25) it indicates a trend is in place. The direction of the trend is determined by whether +DI is above -DI, or vice versa.
Use a crossover trading system by isolating the dominant trend. If the trend is up, take long signals when +DI crosses above -DI. If the trend is down, take short signals when -DI crosses above +DI. Also use the ADX, +DI and -DI to analyze a trend once it is in place.
The ADX indicator does not include profit targets, and a stop loss must be manually implemented based on recent price action. ADX is also prone to “lagging” signals and a reading of 20 or 25 doesn’t necessarily mean a trend will persist. Also, a reading below 20 or 25 doesn’t necessarily mean a trend doesn’t exist, it just may be slow moving.
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