Average directional index (ADX): What does this indicator mean and How can it help us trade?

Thanks to the development of the computer industry, technical analysis becomes more and more popular. It isn’t surprising because previously you needed to make all the calculations by yourself. Now, this task is automated. Today, we are going to describe one of these tools that can help us understand the main tendency of the movement of a certain price in the market. 

An Average directional index (ADX) is a very functional tool that is easy to learn. It is created by three lines. Each of them has its own goal. The first is the line that goes in a positive direction (+DI). Every point of ADX is built as the ratio of the highest point of the last candlestick to the highest point of the previous one.

This instrument is complicated, and a calculation requires several steps. What are they? In practice, if the maximum of the last candlestick is higher than the maximum of the previous one, the line +DI will grow. If lower, the direction will be descending. Look at the graph below and understanding this statement will be easier.

The second line is an indicator that goes in a negative direction (-DI). The algorithm for calculation, in this case, is similar, but we need to compare the lows of the candlesticks. The logic is like in the previous case. When the low of the candlestick is lower than the low of the previous one, the indicator is growing and vice versa.

In this case, both lines are smoothed for a certain period. After calculation, we build an exponential moving average. 

The third line is the Average directional index (ADX) indicator. It is also an exponential moving average, but it is built on the base of -DI and +DI. 

Average directional index (ADX): What does this indicator mean and How can it help us trade?

To put it simpler, an ADX indicator shows not only the direction of the trend. It shows the existence of it and its power. A lot of properties, isn’t it? By the dominance of one or the other line we can understand what direction the trend is going at a certain time (we talk about -DI and +DI).

The third line shows us how intensive this trend is. The highest ADX value is 100. It is a very seldom result. However, even if this indicator is 50 or more, it says about a very powerful trend that is going to be continued for a long time. If the baseline is in the range of 20-50, it means that the trend emerges. If Average Directional Index (ADX) is lower than 20, there is a flat on the market. 

Where can you find this indicator?

If you use MT4, you can easily find the ADX indicator in the main menu of your trading platform. You just need to find “Average Directional Movement Index” in the “Trend” category of the menu for choosing technical indicators.

Average directional index (ADX): What does this indicator mean and How can it help us trade?

Next, you need to set up this indicator. The only setting that you can change in this window is a period of this indicator. This option affects how all the lines of the indicator are built. The longer it is, the smoother the lines will be. Also, you can add levels to the settings window. Average directional index (ADX): What does this indicator mean and How can it help us trade?

If you use another trading platform that supports this indicator (the probability of it is huge), the sequence of your actions is going to be similar. You need to find the required indicator on the menu and set up some properties.

How to use ADX in trading?

ADX is, first of all, a filtering tool that is created for detecting the existence of a powerful trend in certain trading strategies. If an ADX demonstrates the existence of the trend, we can consider signals from other indicators. 

If there is a flat on the market, trend systems are unprofitable. However, ADX can give its own trading signals. There are not many of them and trading with them isn’t profitable in all cases. The most effective signal for entering the market is the crossing of +DI and -DI lines. 

  1. If +DI crosses -DI from the bottom to the top, it means that the market is shifting to the bull’s side. If the ADX line simultaneously goes above 40, it is a signal to open a buy order. 
  2. If -DI crosses +DI from the bottom to the top, the market is on the bear side. If the ADX is higher than 40, you can enter the market with a sell order. 
Average directional index (ADX): What does this indicator mean and How can it help us trade?

However, the condition of the ADX line placing above the level of 40 isn’t required. Different analysts have different opinions. On one hand, if we enter the market every time when +DI and -DI cross, the number of false signals will be significantly higher than the number of profitable orders opened with this indicator. That’s why a lot of traders don’t use this signal in their strategies. 

There is one more reason. Even if the trend is powerful, the level of 40 is reached after 5 or more candles after crossing. As a result, the signal becomes overdue and even if we move in that direction, the most important part of the movement will be lost. 

The optimal moment for entering the market becomes a situation when after powerful movement, the market unfolds and a crossing of the lines is forming in the opposite direction.

Simultaneously, ADX is still placed at high levels, thanks to the previous trend. Therefore, we enter the market in an overbought or oversold state. It gives us additional chances of success. 

Optimal timeframes for using ADX in trading strategies are H4 or above. To make trading profitable in the long-term perspective, it is required that TP is always higher than stop-loss. You need to place orders to exit a trade according to the key levels or local extremums. 

Wrapping up

We answered the question “What is ADX indicator?”. As practice shows us, the ADX indicator is the most effective as a filtering tool in a complex trading strategy. It perfectly suits the trend trading strategies, helps us detect it and avoid losses associated with false signals.

Nonetheless, you should understand that trading in financial markets is a high-risk activity. If you want to reduce losses, you have to follow money management rules and always set a Stop Loss. Only you are responsible for your results. You should understand how to use the ADX indicator now. 

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author

Carolyn Huntington is an economist, professional trader, and analyst. She made her first big deal in her student years with a profitable investment in Facebook stock. Now the total experience of her trade is 18 years. Over the years of trading, Carolyn has developed its own strategy that allows even those who have never traded on the stock exchange before to earn money. She also creates market forecasts and advises major shareholders, compiles investment portfolios, and teaches how to work with automated advisors.

telephone: 503-547-5192