The ADX Methodology

Hello Traders,

I welcome you to Friday’s educational article on the ADX indicator.

The ADX is actually the abbreviated term. On some platforms you will need to search for “Average Directional Index” “Average Directional Movement Index”.

Basically the ADX is a lower case indicator which any trader can add to their chart and you should be able to find as a standard tool on all platforms. If you wonder why a trader should have the need for an indicator, you might want to take a look at the article “why use indicators” for more information.

The ADX intro

The ADX was created by Welles Wilder, who wrote about the indicator in his book of 1978 named “New Concepts in Technical Trading Systems.” His book also included work on the Average True Range (ATR), the Parabolic SAR, and RSI. More information on this in the articles “how to trade the parabolic sar indicator” and “the average true range”.

Wilder designed ADX with commodities, Forex and daily prices in mind, but these indicators can also be applied to stocks.

The Average Directional Movement Index is a great tool to have in your box of analytic “weapons”. We will discuss how to use the ADX indicator in the remainder of the article. But before we dive into the usage of the tool, let us go through the main benefits of the indicator.

Main benefit / biggest strength

The biggest added value and the ADX’s unique feature is the fact that it focuses on measuring the strength or weakness of a trend. But it can also define trend direction.

Most other indicators are only able to identify a directional bias of the market or the strength of momentum, but not both.

For example, oscillators with oversold and overbought values indicate areas in which price has overextended to one of the 2 sides. The oscillators attempt to establish which side of the market is in an extreme.

The ADX also provides a definition of a trend direction in the market. However, the ADX quantifies the strength or lack of strength of any market movement. Basically it can establish if there is a trend and if how strong has it developed so far.

The ADX therefore can be a great tool and can be a valuable indicator for your Forex trading strategy and Forex trading plan. In some cases, a trader can get the best Forex trading advice from these tools.

The indicator

Wilder calculated the directional movement by comparing the difference between two consecutive lows with the difference between the highs. The Average Directional Index indicator has 3 lines in its indicator:

1)      The ADX itself

2)      Minus Directional Indicator (-DI)

3)      Plus Directional Indicator (+DI)

They represent a group of directional movement indicators that form a trading system. The Average Directional Index indicator does this as follows:

  • The ADX measures trend strength without regard to trend direction. This allows traders to identify whether there is a good environment for their trend following system or a non-trend following system.
  • The other two indicators, Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), identify trend direction.  The upside has an edge when +DI is larger than – DI, while the downside has an edge when – DI is greater. Crosses of these two lines indicate change in the direction.

When a trader combines this two analysis, they are able to distinguish both the direction and strength of the trend in one indicator.

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The value of the ADX

Wilder suggests that a strong trend is unfolding when the ADX is above the value of 25. When the value is lower than 20, it means that no trend is present and the currency is in a range bound environment. Wilders considered the zone between 20 and 25 to be in between. Many technical analysts however use 20 as the key level for ADX.

The value of the+DI & -DI

The directional movement is positive or plus when the current high minus the prior high is greater than the prior low minus the current low.
- Provided the answer to the above is positive, the Plus Directional Movement (+DM) then equals the current high minus the prior high. A negative value would mean that the +DM is zero.

The directional movement is negative or minus when the prior low minus the current low is greater than the current high minus the prior high.
- Provided the answer to the above is negative, the Minus Directional Movement (-DM) equals the pior low minus the current low. A positive value would mean that the –DM is zero.

Trading with the indicator

Wilder created a simple trading strategy and trading plan which is based on the three parts or lines of the indicator.

The first condition is connected to the value of the ADX, which should be above 25. Many traders however use 20 as the minimum value. This ensures that the currency is trending.

A long signal occurs when +DI crosses above – DI. Wilder placed his stop loss under the low of the trigger candle (day candles in his case). The trend remains in force as long as the low is not broken. A cross of +DI below – DI would not signal a change and would be treated as retracement until a low is penetrated. The trend will most likely strengthen when the ADX turns, which will confirm the trend. Once the trend is in profit, the trader can use a trailing stop method to lock in profits along the way.

The opposite is needed for a short trade setup.

Summary

The ADX is a simple yet interesting tool for making analysis. Of course it goes without saying that proper back testing should be completed by every trading on the currency or currencies which you trade before actual implementation or use of this indicator. Using other indicators as a confirmation for your analysis is always recommended as well. Using trend lines, chart patterns, Fibonacci levels and Elliott Wave are just but a few examples of technical analysis what can be used for that confirmation.

I hope that this to “how to use the ADX indicator” article has helped you and hope that it will improve your Forex trading plan and Forex trading strategy.

Questions

Last but not least, I want to ask you:

Do you use this indicator?
Do you intend to check out this indicator after reading this article?
Let us know in the comment section below!

Sharing

If you find this an interesting indicator and article, please share this information with other traders as well.
I wish you a Good Trading and a nice weekend.

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Chris is the head of the mentoring program and trading room at Winner's Edge Trading. He has a passion for technical analysis and helping Forex traders achieve their goals in trading. Chris has been trading for almost 10 years and is most fond of the Double Trend Trap (as a strategy), moving averages (as an indicator) and Fibonacci (as a tool).
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