Trading can sometimes be challenging because of the overwhelming amount of information, the rapid pace at which markets move, and the challenge of finding trustworthy resources. When markets are performing well, investors may worry they’ve missed the opportunity and a correction is imminent.
On the other hand, when markets are underperforming, they might fear losing money by investing at that moment. However, traders do not always have to be on edge as there are tools that can help you make trading easier and more profitable.
One of these is the Average Directional Index (ADX), a technical indicator that traders use to determine the strength of a trend in the financial markets, including stocks, forex, and cryptocurrencies. Developed by J. Welles Wilder in 1978, ADX is a vital tool in any trader’s arsenal, helping to distinguish between strong trends and weak, sideways-moving markets.
This article will explore what ADX is, how it works, and how you can use it to make informed trading decisions.
Key Takeaways
- The Average Directional Index (ADX) measures trend strength, ranging from 0 to 100.
- ADX values above 25 indicate a strong trend, while values below 25 suggest a weak or sideways market.
- Traders combine ADX with indicators like RSI and moving averages for confirmation.
- ADX doesn’t show trend direction, only strength, so use +DI and -DI for that.
What is the Average Directional Index (ADX)?
The Average Directional Index (ADX) is a trend strength indicator that moves between 0 and 100. Unlike most technical indicators, ADX doesn’t show the direction of the trend but only its strength. A high ADX value indicates a strong trend, while a low value suggests a weak or non-trending market.
Wilder developed the ADX as part of a broader system that includes two other indicators: the Plus Directional Indicator (+DI) and the Minus Directional Indicator (-DI). These two components measure the direction of the trend, while ADX focuses solely on the strength.
How Does the ADX Work?
The ADX is calculated based on the moving averages of the Directional Movement Index (DMI), which in turn compares successive price ranges. The standard setting for the ADX indicator is 14 periods, though analysts may adjust this to as low as 7 or as high as 30.
Using a lower setting allows the ADX to react more quickly to price movements but increases the risk of generating false signals. Conversely, higher settings reduce false signals but make the ADX more of a lagging indicator.
To calculate the ADX, Wilder first derived the positive directional movement index (+DMI) and the negative directional movement index (-DMI), which compare the current period’s high and low prices with those of the previous period. The ADX is then computed based on the differences between +DMI and -DMI over a specific period.
Although these calculations are complex, traders don’t need to do them manually. By applying the ADX indicator to a chart, the calculations are automatically handled by the platform, with the default setting typically at 14 periods.
Additionally, the ADX fluctuates between 0 and 100, and traders typically interpret it using the following general guidelines:
- 0-25: Reflects a weak trend or a sideways market.
- 25-50: Suggests a moderately strong trend.
- 50-75: Indicates a strong trend.
- 75-100: Shows a very strong trend.
An ADX reading below 25 signals that the market is likely in a ranging phase, while a reading above 25 suggests a trending market. When the ADX is rising, the trend is strengthening, and when it’s falling, the trend is weakening.
Note that while the ADX can be a useful tool for identifying the strength of emerging trends, it does not pinpoint specific buy or sell opportunities. Instead, the ADX helps traders assess whether an ongoing trend is strong enough to justify an investment or if it’s better to wait for a more defined trend to develop.
“An investor who has all the answers doesn’t even understand the questions. Success is a process of continually seeking answers to new questions.”
— John Templeton, fund manager and banker
Components of ADX
The ADX consists of three lines:
ADX Line: The primary line that indicates trend strength. It is a smoothed moving average of the absolute difference between the +DI and -DI lines.
+DI Line (Positive Directional Indicator): Measures the upward price movement. When the +DI is above the -DI, the market is trending upward.
–DI Line (Negative Directional Indicator): Measures the downward price movement. When the -DI is above the +DI, the market is trending downward.
The interaction between these three lines provides a comprehensive view of both the strength and direction of a trend, allowing traders to make more informed decisions.
How to Calculate ADX
A thorough understanding of how the ADX is calculated can help traders better interpret its signals. The calculation involves several steps:
1. Directional Movement (DM): Compare the current high to the previous high and the current low to the previous low. If the current high exceeds the previous high, this is positive directional movement (+DM).
If the current low is lower than the previous low, this is negative directional movement (-DM).
2. True Range (TR): The true range is the largest value of the following:
- Current high minus current low
- Current high minus previous close
- Current low minus previous close
3. Smoothed Moving Averages of DM and TR: Wilder used a smoothing technique to calculate the moving averages of both DM and TR, which form the basis for the +DI and -DI values.
4. DX (Directional Index): The DX is the absolute difference between the +DI and -DI divided by their sum.
5. ADX: The ADX is a smoothed moving average of the DX values over a specific period (usually 14 periods).
Hence, we have this formula:
+DI = ((Smoothed MA + DM) / ATR) * 100
-DI = ((Smoothed MA – DM) / ATR) * 100
DX = ((+DI – -DI) / (+DI + -DI)) * 100
First ADX Calculation: ADX = sum of DX over n periods / n
Subsequent ADX Calculation: ADX = ((Prior ADX * (n – 1)) + Current DX) / n
Where:
+DM = Current High – Previous High
-DM = Previous Low – Current Low
ATR = Average True Range
N = Number of periods used in the calculation (the default is typically 14, but traders can adjust this as needed)
These calculations generate the three lines of the ADX indicator. The +DI (green line) represents the positive directional indicator, while the -DI (red line) represents the negative directional indicator.
Also, the ADX (black line) is a non-directional indicator that reflects the average difference between +DI and -DI, plotted on a scale from 0 to 100, with no negative values. Note that while most traders use charting software to automate these calculations, it’s beneficial to understand the formula to grasp how the indicator responds to market movements.
How Traders Can Use the ADX
Traders use the ADX in conjunction with the +DI and -DI to identify profitable trading opportunities. Here are some common strategies:
Crossover
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The primary objective of using the ADX is to focus on identifying qualified opportunities in trending markets. One key signal to watch for is the crossover between the +DI (Positive Directional Indicator) and -DI (Negative Directional Indicator) lines.
When the +DI line crosses above the -DI line, it suggests that the rate of positive price movement is greater than the negative movement. If this occurs while the ADX is above 25, it provides a strong buy signal.
Conversely, when the -DI line crosses above the +DI line, it indicates that the negative price movement is outpacing the positive, signaling a selling opportunity, especially if the ADX is below 25.
Crossover signals can be used not only for trade entries but also for managing and exiting trades. For example, if you are in a long position and notice the -DI crossing above the +DI, you may want to safeguard profits by using trailing stops or closing the position entirely.
Identifying Trend Strength
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When the ADX rises above 25, it signals that a strong trend is forming. The +DI and -DI lines help confirm the direction of that trend.
For instance:
- Buy Signal: If the ADX rises above 25, and the +DI line crosses above the -DI line, it’s considered a bullish signal.
- Sell Signal: If the ADX rises above 25, and the -DI line crosses above the +DI line, it’s considered a bearish signal.
Trend Reversals
The ADX can also help identify when a trend is losing momentum. If the ADX starts to decline from a high level, it suggests that the current trend is weakening, potentially leading to a reversal.
However, traders should use other indicators to confirm the reversal, as a falling ADX doesn’t necessarily mean the trend will reverse as it could just be consolidating.
Avoiding Range-Bound Markets
When the ADX is below 25, the market is typically in a sideways or ranging phase. During these periods, trend-following strategies are less effective, and traders may look for range-bound strategies instead, such as buying support and selling resistance.
Breakouts
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Breakouts from a range-bound market can offer significant trading opportunities, but distinguishing between valid and false breakouts is often challenging. The ADX is helpful in validating these breakouts.
When a price breaks out with an ADX reading above 25, it indicates that momentum is strong and the breakout is likely to be sustainable. However, if the ADX reading is below 25 during a breakout, it could suggest that the breakout lacks sufficient momentum and may be unsustainable, potentially trapping traders in bad positions.
“Being a value investor means you look at the downside before looking at the upside.”
— Li Lu, businessman and investor
Combining ADX With Other Technical Indicators
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ADX works best when combined with other indicators:
ADX and Exponential Moving Average (EMA)
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Pairing ADX with the Exponential Moving Average (EMA) can enhance trading results. ADX identifies whether the market is trending or range-bound, while the EMA pinpoints the direction and momentum of that trend.
Traders often look for signals such as the “Golden Cross” (indicating a bullish trend) or the “Death Cross” (indicating a bearish trend) to inform their decisions. For example, if the EMA is above 20, it may suggest a buying opportunity.
However, since EMAs can sometimes produce false signals, the ADX can filter these out. A strong confirmation would be when the ADX line crosses above 20, validating the signal.
ADX and RSI
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The Relative Strength Index (RSI) works well with the ADX to enhance your trading strategy. RSI measures the speed and magnitude of price changes, helping to spot overbought or oversold conditions.
RSI readings above 70 indicate overbought conditions, while readings below 30 suggest oversold conditions. Traders can use the RSI to find potential reversals and combine it with ADX to determine the strength of those reversals.
Essentially, ADX adds another layer of confidence by measuring whether the trend has enough momentum to sustain the reversal.
ADX and MACD
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The Moving Average Convergence Divergence (MACD) is another effective tool when used alongside the ADX. The MACD histogram helps traders identify trend direction: values above zero suggest a bullish trend, while values below zero indicate a bearish one.
Combining MACD with ADX boosts the accuracy of trade predictions. For instance, if the MACD histogram is above zero, the ADX should be above 25 to confirm a buy signal.
Further confirmation comes when the +DI crosses above the -DI, indicating stronger buying momentum.
Importance of ADX in Technical Analysis
The Average Directional Index (ADX) plays an important role in technical analysis because it measures the strength and momentum of trends, helping traders identify potential opportunities in any market. According to estimates from Grand View Research, the global market is projected to expand at a compound annual growth rate (CAGR) of 12.5% by 2030.
In this case, adding the knowledge of ADX to your trading techniques is a good step in the right direction. Basically, by quantifying the momentum behind a trend, ADX provides you with an objective way to determine when a trend is strong enough to trade, making it especially useful for spotting trade setups and trend reversals.
Key Benefits
Here are some of the key benefits the technical indicator offers traders;
Trend Strength Measurement
ADX helps traders assess whether a trend is strong and likely to continue, or if it is weakening and potentially reversing.
Early Warning of Trend Reversals
ADX can alert traders when a trend is losing strength, allowing for timely exits or adjustments to trading strategies.
Versatility
The ADX can be applied across different markets, timeframes, and trading styles, making it a valuable tool for a wide range of traders.
Enhancing Risk Management
By identifying weak trends or reversals early, ADX aids in better risk management, helping traders avoid unfavorable conditions that could result in losses.
Confirmation Tool
ADX works effectively when combined with other indicators like momentum oscillators, moving averages, or price action. When multiple analysis techniques align, traders gain more confidence in their decision-making.
Although the ADX does have limitations, when used correctly, it enhances trading strategies by providing critical insights into trend strength and potential changes in market direction, contributing significantly to successful trading outcomes.
Limitations of ADX
While the ADX is a powerful tool, it does have some limitations:
Lagging Indicator
The ADX is based on historical data and moving averages, which makes it a lagging indicator. This means it can confirm trends after they’ve already begun, potentially causing traders to enter positions late.
Non-Directional Nature
Although the ADX measures trend strength, it doesn’t specify the direction. Traders must rely on the +DI and -DI lines to interpret whether the trend is bullish or bearish.
Sideways Markets
In markets that experience prolonged periods of low volatility or sideways movement, the ADX may give false signals. During these phases, trend-following strategies may underperform, and traders need to adjust their approach.
“Great investors need to have the right combination of intuition, business sense, and investment talent.”
— Andrew Lo, Economist and businessman
Using ADX in Crypto Trading
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Here are some practical tips on leveraging the Average Directional Index (ADX) for effective crypto trading:
Identifying Trend Strength
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The ADX is primarily used to gauge the strength of a trend. Its value ranges from 0 to 100. A high ADX reading, such as above 70, indicates a strong trend, whether bullish or bearish. On the other hand, a low ADX reading, below 20, signals a weak or ranging market.
Confirming Trend Direction
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In addition to measuring trend strength, the ADX helps confirm the direction of a trend. When the +DI (Positive Directional Indicator) is above the -DI (Negative Directional Indicator), it suggests a bullish trend.
Conversely, when the -DI is above the +DI, it indicates a bearish trend. Traders often look for crossovers between the two as signals to enter or exit trades.
Using ADX as a Filter
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ADX is commonly used by crypto traders as a filter to refine their trading strategies. For instance, in a trend-following approach, traders might only take buy signals when the ADX is above a specific threshold, such as 25, ensuring they enter positions when a strong trend is in place.
This helps avoid entering trades during periods of low momentum or weak trends.
Evaluating Breakout or Breakdown Momentum
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When the price of a cryptocurrency breaks above resistance or below support, ADX can help confirm the momentum behind the breakout or breakdown. A rising ADX above 25 suggests strong momentum, indicating the breakout is likely to continue, which provides a good opportunity to enter or add to long positions.
If the ADX is falling or below 25, it signals weak momentum, suggesting traders should exercise caution or wait for further confirmation before making a move.
Now, let’s consider a real-world example using Bitcoin as an asset. Suppose Bitcoin is trading at $30,000, and the ADX line starts to rise above 25, with the +DI crossing above the -DI line. This would suggest that Bitcoin is entering a strong upward trend.
A trader could then decide to enter a long position, betting that the price of Bitcoin will continue to rise. Later, if the ADX begins to fall but stays above 25, it might indicate that the uptrend is losing strength.
The trader might consider tightening stop-loss orders or taking partial profits. If the ADX falls below 25, the trader might exit the position entirely, assuming the trend has run its course.
Conclusion
The Average Directional Index (ADX) is a valuable tool for traders looking to gauge the strength of a trend in the financial markets. By providing insight into whether a market is trending or range-bound, ADX helps traders avoid whipsaws and focus on high-probability setups.
While it’s not a standalone solution, combining ADX with other indicators like moving averages, RSI, and MACD can significantly improve trading outcomes. Therefore, understanding how to read and interpret ADX, along with its limitations, will give you a more well-rounded approach to trend analysis and help you make more informed trading decisions.
FAQs
What is ADX?
ADX, or Average Directional Index, is a widely used financial trading indicator that has been around for nearly fifty years. It provides valuable insights into cryptocurrency markets.
How do I use ADX?
Typically, the ADX indicator includes three trend lines, but the ADX line itself is the most effective for generating actionable signals. Traders monitor the relationship between the ADX line and the 25 level on its 0-100 scale, as well as its direction, to confirm entry or exit points based on the trend’s behavior.
What is the optimal ADX setting for day trading?
The standard setting for the ADX indicator is a 14-day period. However, this can be adjusted based on individual trader preferences, with settings ranging from as low as seven days to as high as 30 days.
What is the Best Indicator to Use with ADX?
The ADX is most effective when used alongside other technical indicators, such as the Relative Strength Index (RSI). While the ADX gauges the strength of a trend, the RSI provides a time-based element that assists in determining entry and exit points within that trend.
