 As a part of the Directional Movement System developed by J. Welles Wilder, this indicator helps traders assess whether the market is trending or moving sideways.Â
With the power to filter out noise and highlight the strength of a trend, the ADX has become a staple for traders of all levels, from beginners to pros.Â
This article will take a closer look at the ADX indicator, its components, how to interpret it, and how traders can make use of it in an effort to make better decisions.
Understanding the ADX Indicator
The ADX is a technical analysis tool that provides the strength regarding a trend. Unlike many other indicators that could also suggest whether the trend is bullish or bearish, the ADX is strictly a reading of trend strength.Â
This makes it somewhat unusual in the world of technical indicators, which often seek to measure trend direction. In other words, the ADX does not tell you if the market is up or down but rather how strong or weak the movement is.
The ADX was developed by J. Welles Wilder back in the 1970s. The ADX forms part of a larger system known as the Directional Movement System, which also includes two other indicators: the +DI or Positive Directional Indicator and the –DI or Negative Directional Indicator.
 The ADX itself is a smoothed moving average of the difference between the +DI and –DI, a measure of trend strength. To effectively use the ADX, one needs to understand how these three components work in concert.
Components of the ADX Indicator
1. +DI (Positive Directional Indicator)
The +DI reflects the magnitude of the upward price movement. If the +DI is above the –DI, this means that the market is in an uptrend, and there is more upward price action than downward.
2. –DI (Negative Directional Indicator)
The –DI measures the strength of the downward price movement. When the –DI is above the +DI, it signals that the market is in a downtrend, with more downward pressure than upward.
3. ADX (Average Directional Index)
It indicates the strength of a trend, whether upward or downward. The ADX accomplishes this by finding the difference between the +DI and -DI values, smoothes out that difference, and plots it as a value on a 0-100 scale. If an ADX is rising then, this shows an uptrend; if it’s falling then that depicts a weakening trend in prices.
How the ADX Indicator Works
To take full advantage of the power of the ADX indicator, one needs to understand how to read it. The values of the ADX range from 0 to 100, with each value representing a different level of trend strength:
0-25: This is usually a weak or no trend area. Within this zone, the market is normally range-bound, moving sideways, with no clear direction.
25 to 50: Within this range, the value indicates a moderately strong trend. The market is trending but may still have some consolidations or retracements. At this stage, traders could start considering directional trading strategies.
50 to 75: Here, the trend is strong. The market will continue to move in the direction of the trend, and the traders can grab the opportunity for substantial price movements.
75 to 100: A very strong trend. A powerful directional move is going on in the market. This is where the trader could expect sustained momentum, although caution is warranted as most such strong trends often end up overextended and at a risk of reversal.
How to Use the ADX Indicator for Trend Analysis
The ADX indicator can be used in many ways to identify strong trends and make informed trading decisions. Below are some key methods of using the ADX for trend analysis.
1. Identifying Trend Strength
As discussed, the ADX is first and foremost a tool of measuring trend strength. Traders use it to distinguish between trending and non-trending markets. When the ADX is below 25 that is, in a low ADX environment traders can avoid trend-following strategies as the market has no clear direction.Â
Conversely, traders may look to follow trends in markets where the ADX is above 25. This is the power of the ADX; it helps traders avoid times when there are false breakouts or range-bound conditions, where any trend is weak and unreliable.
2. Combining ADX with +DI and –DI
While the ADX gauges the strength of the trend, it does not define the direction. That is where the +DI and –DI components become very important.Â
When the +DI is above the –DI and the ADX is rising above 25, that suggests a strong uptrend. Conversely, when the –DI is above the +DI and the ADX is rising above 25, this suggests a strong downtrend.
For instance, a trader might want to see the following: when the +DI is greater than the –DI, signaling a bullish trend; then the ADX is over 25, showing strength in the trend. Thus, the trader may now enter a long position anticipating the continuity of the trend.
Similarly, if:
- The –DI is above the +DI, which in turn indicates a bearish trend;
- The ADX is above 25, representing a strong trend;
- One would then open a short position in expectation of a continued downside move.
3. Confirmation of Breakout using ADX
Many traders use the ADX to confirm the strength of a breakout. When a market is in a consolidation phase and then breaks out of a support or resistance level, the ADX can help confirm whether the breakout is likely to lead to a strong trend or is a false signal.
- If the ADX is above 25 when the breakout occurs, it indicates that the breakout is supported by a strong trend.
- If the ADX is below 25, the breakout may lack sufficient strength, and the trader should be cautious about entering a trade.
4. ADX and Trend Reversal Signals
When ADX falls, it means the weakening of a trend. At some instances, this could form reversals. Traders like seeing ADX start turning down after reaching a high value above 50 this will indicate that the present trend is losing momentum, possibly looking at setups for a potential reversal in trend.
5. Avoiding Choppy Markets
One of the strongest benefits of the ADX is that it can help traders avoid choppy or sideways markets. When the ADX is low (less than 25), price action tends to be erratic, and it’s hard to make any money using trend-following methods.Â
By looking for markets with higher ADX readings, traders can increase their chances of success by trading in more predictable, trending conditions.
Best Practices for Using the ADX Indicator
While the ADX is a great trend analysis tool, it is good to use it in conjunction with other indicators or other technical tools to form an overall trading strategy. The following are some best practices in using the ADX indicator:
1. ADX and Trend Indicators Combination
The ADX gives insight into the trend strength but does not provide entry and exit signals. Combining it with other trend-following indicators such as Moving Averages or Relative Strength Index RSI may be of great assistance in order to come up with a much more distinct trading strategy.
2. Use ADX for Filtering Trades
Instead of taking the ADX as an indicator for entry signals, use it as a filter for other signals. For instance, if the ADX is below 25, it would be better to avoid taking up any trade depending on other indicators only, as it reflects weak trends.
3. Pay Attention to ADX Divergence
The divergence between price action and the ADX can point to a possible reversal. For instance, if the price is making new highs while the ADX fails to rise above previous levels, it could mean that the trend is weakening, and a reversal may be near.
4. Don’t Overtrade
Even though the ADX is an excellent indicator for strong trends, bear in mind that not all trends are big winners. Always use proper risk management techniques and never overtrade, even when the ADX shows strong trends.
5. Know Market Conditions
The ADX works best in trending markets and does not work well in range-bound conditions. Be sure to assess market conditions before using the ADX as a single tool for trend analysis.
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Frequently Asked Questions (FAQs)
Does the ADX indicate the direction of the trend?
- No, the ADX itself is used only to measure the strength of a trend, not its direction. To know the direction, traders must consider the +DI and -DI components. If +DI is above -DI, the trend is bullish, and if -DI is above +DI, the trend is bearish.
How does the ADX compare to other trend indicators?
- Unlike moving averages or trendlines that give indications of direction, the ADX gives information on the strength of the trend. As such, it complements other ways of identifying trends, confirming their validity.Â
What timeframe is the ADX best used over?
- The ADX can be used over a variety of timeframes; however, its effectiveness will depend upon your trading style. The shorter time frames, like 5-minute or 15-minute charts, suit best the day traders, while daily or weekly charts are ideal for swing traders or investors.
Does ADX indicate entry and exit?
- This, in itself, the ADX does not give any entries and exits; however, the indicator can affirm the strength of the trend. Many traders end up combining it with other indicators such as moving averages or oscillators to find better entry and exit spots.
What are common settings for the ADX indicator?
- The default setting for the ADX indicator is a 14-period calculation. However, traders can adjust the period based on their trading strategy. Shorter periods may provide faster signals but are more prone to noise, while longer periods offer smoother readings.
