What is the Average Directional Index?

What is the Average Directional Index?

Trend indicators are a popular class of technical indicators for both short-term and long-term traders. These indicators help quantify the overall strength of a trend. One of them is the Average Directional Index or Average Directional Movement Index, also known as ADX. Along with the Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI), the ADX forms a group of directional movement indicators, in a part of the trading system developed by Welles Wilder.

Although Wilder designed these indicators with commodity and daily price action in mind, they can also be used in the currency and stock markets. Wilder developed the system along with Parabolic SAR and Average True Range (ATR), much before the electronic or computerised age of trading. Even then, they were incredibly detailed in their calculations and have helped many traders through the years.

Calculations of Average Directional Index

The ADX indicator, together with two accompanying indicators (+DI and –DI), forms three separate lines. These lines help traders assess whether to go for a long or short position or avoid entering a trade at all.

ADX requires a sequence of calculations for the three lines:

+DI = (Smoothed +DM/ATR) X 100

– DI = (Smoothed –DM/ATR) X 100

DX = (|+DI – -DI|/ |+DI + -DI|) X 100

ADX = ((Prior ADX X 13) + Current ADX) / 14

Where: +DM (Directional Movement) = Current High – Previous High

               -DM = Previous low – Current low

               TR = Greater of the (Current High – Current Low, Current High – Previous Close, or Current Low – Previous Close)

               Smoothed +/-DM = Smoothed 14-period average of +DM, -DM, and TR

               CDM = Current DM and ATR = Average True Range

How Does It Work?

ADX calculations are based on the moving average of price expansion for a specific period of time. While the default setting is 14 bars, other time periods can be used as well. Together, the three indicators act as momentum indicators, with ADX signifying trend strength, and +DI and –DI showing the trend direction.

By determining the values of ADX, traders can ascertain whether a particular trend is strong enough to continue. A value above 25 signifies strength, while below 25 is usually avoided by traders.

ADX Value Trend Strength
0-25 Weak Strength
25-50 Strong Strength
50-75 Very Strong Strength
75-100 Extremely Strong Strength

 

In case the ADX is below 30 for consecutive 30 bars, prices tend to start ranging and become easier to identify. Then, they start fluctuating between the resistance and support levels, to generate selling and buying interests, respectively. It is when the ADX is above the value of 25 that prices begin to trend.

The direction of the ADX line also determines the trend strength. When the line rises, it signals an increase in strength, when prices start moving in the direction of the trend. When the line falls, prices retrace or consolidate. Contrary to common belief, a declining line doesn’t necessarily indicate trend reversal. It only indicates a weakening trend. As long as the value is above 25, the trend exists.

Identifying Trade Signals

The crossovers and movements of the +DI and –DI lines are very helpful in generating trade signals. In case the value of the ADX is above 25 and the +DI line is crossing over the –DI line, it could be a signal to enter a long position.

Similarly, when –DI crosses over the +DI line, and the ADX value stays above 25, it indicates a potential signal for a short position. In the same way, these crosses can tell traders whether to enter or exit a trade.

If already in a long position, and the –DI is crossing over the +DI line, then it is considered a good time to exit a trade. In all these cases, the value of ADX remains above 25. If the value falls below 20, it signals a ranging market, not suitable for trending strategies. However, even here, traders often enter into long positions at support and short positions at the resistance level.

ADX can also point towards momentum divergence. When prices are making higher highs and ADX makes a lower high, it means non-confirmation or negative divergence. This could be a warning that the trend momentum is changing and that traders should tighten their stop-losses and take-profits while they still can. It is always wise to manage risk, whenever a trend changes character.

Using the Forex ADX Indicator for MT4

If you are overwhelmed seeing the number of calculations involved, you need to know that modern trading software, like MT4, performs all these calculations for you. The MT4 platform comes equipped with the ADX indicator for forex, CFDs and indices.

To use ADX in MT4, you will need to enter the period. You can change the indicator properties, to give distinctive colors to the +DI and –DI lines. The default period value is always 14 and, characteristically, you will see three lines below the main price chart. The thick blue line is for ADX itself, while the dotted green and red lines are +DI and –DI, respectively. The MT4 ADX is an advanced version of the indicator, compared to what Wilder originally introduced.

Limitations of ADX

The main problem with ADX is fast occurring crossovers, which sometimes occur too frequently, resulting in confusion for traders. These are commonly known as false signals. Sometimes, the value of ADX can go above 25, only to retrace in a matter of minutes.

When an indicator is used, it should be able to provide some information that price alone cannot convey. So, a good approach could be to study the price first and then take a look at what ADX is signalling. ADX can allow traders to find changes in trend momentum, which gives them time to ensure risk management. You can also combine ADX with another indicator to see whether a currency pair is headed upwards or downwards.

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