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The Average Directional Index or ADX is a popular technical analysis indicator used to measure trend strength and help traders determine whether a market is trending or in a range. Developed by J. Welles Wilder, it is a key indicator included in many trading platforms and charts.

The ADX provides traders with valuable insights into the prevailing trend by highlighting periods of strong directional movement compared to periods of consolidation or sideways trading. By understanding how it is derived and interpreted, traders can develop robust strategies around the ADX.

What is the ADX Technical Indicator?

The ADX measures trend strength on a scale of 0-100. It was created by Wilder and introduced in his seminal 1978 book, New Concepts in Technical Trading Systems. At its core, the ADX analyzes the degree of directional movement over time to quantify trend behavior.

Specifically, the ADX indicator is calculated using three variables:

  • Positive Directional Indicator (+DI) – Measures the strength of an uptrend over a given period.
  • Negative Directional Indicator (-DI) – Measures the strength of a downtrend over the same period.
  • Directional Movement (DM) – Measures the direction and strength of price movement between each period.

By comparing the relationships between these three components, the ADX is able to objectively quantify trend strength on a consistent numerical scale. This makes it a very useful technical indicator for traders.

How is the ADX Calculated?

To understand how the ADX itself is derived, it’s important to first examine the calculations that go into its three underlying variables:

Positive Directional Indicator (+DI)

The +DI is an exponential moving average of the Positive Directional Movement values over the specified period (usually 14 periods).

Positive Directional Movement is the greater of the current high-low range or the previous close-high range. This measures the strength of upward price movements.

Negative Directional Indicator (-DI)

Similarly, the -DI is an exponential moving average of the Negative Directional Movement values.

Negative Directional Movement is the lesser of the current high-low range or the previous close-low range. This measures downward price movements.

Directional Movement (DM)

DM is simply the sum of the absolute values of daily price changes. It measures the vector magnitude of price changes regardless of direction.

With the components defined, the ADX itself can now be calculated. It is simply a smoothed average of the absolute value of the ratios of TR to DM+ over the period. This produces the final ADX output ranging between 0-100.

How is the Directional Movement (DM) Calculated?

As mentioned, the Directional Movement (DM) is a key input in calculating the ADX. It measures the direction and strength of price movement between each period.

Specifically, DM is derived as follows:

  1. Calculate the True Range (TR) for each period. TR is the greatest of:
    • The current high less the current low
    • The absolute value of the current high less the previous close
    • The absolute value of the current low less the previous close
  2. Calculate the Positive Directional Movement (+DM) as the period’s TR if the current high is higher than the previous period’s high.
  3. Calculate the Negative Directional Movement (-DM) as the period’s TR if the current low is lower than the previous period’s low.
  4. Sum the +DM and -DM values to get the total Directional Movement (DM) for the period.

So in summary, DM looks at the high-low range each period and assigns it as either positive or negative movement based on the direction of price change from the previous period. The sum of all DM values over the specified timeframe is then used to calculate the ADX.

Understanding the DM calculation is important because it forms the basis of how the ADX quantifies trend direction and strength on each timeframe. Let’s now examine how the ADX line itself is derived from these components.

Understanding the ADX Line Itself

With the components defined, we can now examine how the ADX line is actually calculated. As a refresher, the ADX line ranges between 0-100 and indicates the strength of the prevailing trend.

The calculation is as follows:

  1. Calculate the Positive Directional Indicator (+DI) and Negative Directional Indicator (-DI) over the specified period (usually 14 periods).
  2. Calculate the True Range (TR) over the same period.
  3. Calculate the Positive Directional Movement (+DM) and Negative Directional Movement (-DM) values.
  4. Calculate the Directional Movement Index:DM+ / TRThis produces a ratio between 0-1 measuring trend direction for the period.
  5. Take the absolute value of the differences between the current and previous period’s Directional Movement Index ratios.
  6. Calculate an n-period simple moving average (usually 14 periods) of the absolute differences.
  7. Multiply by 100 to scale the final ADX output between 0-100.

In essence, the ADX line is a smoothed average of the absolute value of the ratios of TR to DM+. This filters out noise and volatility to clearly indicate the prevailing directional movement over time. Periods where the ADX rises above common thresholds like 25 indicate a strong established trend.

The ADX provides traders with an objective measure of trend strength on each timeframe. In the next section, we’ll examine how to interpret ADX readings in more detail.

How to Interpret ADX Readings

With an understanding of how the ADX is calculated, we can now examine how to interpret readings of the indicator itself. Here are some common guidelines:

Above 25 indicates a strong trend:

  • An ADX value above 25 suggests the presence of a strong and established trend, whether up or down. This is the most common threshold to watch.

Below 20 signals a weak trend or consolidation:

  • Readings below 20 imply there is no dominant trend and the market may be transitioning or consolidating in a range-bound state.

Crossovers:

  • Crossovers of the ADX line above/below thresholds like 25 can provide buy/sell signals of a trend beginning or ending. For example, a crossover to above 25 signals the start of a strong trend.

Relation to DI lines:

  • A rising ADX alongside a rising +DI or -DI reinforces the trend direction. A declining ADX with flattening DIs implies the trend is weakening.

Higher numbers = stronger trend:

  • The higher the ADX number, the more dominant and stronger the prevailing trend tends to be. Readings above 30 represent very robust trends.

Divergences:

  • Divergences between the ADX and price can also signal potential trend reversals, like when ADX is falling but price makes new highs.

The key is that the ADX provides an objective measure of trend behavior over time. Traders can develop strategies leveraging these interpretations of its common signals and thresholds.

Here are a few strategies both for day traders and longer-term technical analysis using the ADX to identify trends in forex, crypto, and stock markets:

Day Trading Strategy #1 – ADX Trend Follower:

  • Set ADX period to 14 bars
  • Enter long when ADX rises above 25 and +DI is above -DI
  • Enter short when ADX is above 25 and -DI is above +DI
  • Place initial stop loss at 2x the average true range beyond entry
  • Take partial profits at key resistance/support levels
  • Move stop loss to breakeven on remaining position

Swing Trading Strategy #2 – ADX & Moving Average Crossovers:

  • Plot a 34-period simple moving average on the chart
  • Enter long when price crosses above SMA and ADX is rising above 20
  • Enter short when price crosses below SMA and ADX is above 20
  • Set initial stop at last crossover point of SMA and price
  • Take profits on a moving average crossover in the opposite direction

Longer-Term Strategy #3 – ADX Divergence Trades:

  • Watch for divergences between ADX and price action
  • Go long when ADX makes a new relative low but price makes a higher high
  • Go short when ADX makes a new relative high but price makes a lower low
  • Use moving averages to help confirm the reversal of trend
  • Set wider stops given longer holding periods

The key is combining ADX signals with other indicators or price action filters to develop robust strategies suitable for different timeframes and risk appetites. The ADX is a versatile tool when interpreted correctly.

FAQs About the ADX Technical Indicator

Here are answers to some frequently asked questions about the ADX indicator:

How does ADX compare to other trend indicators?

The ADX measures trend strength on a consistent scale from 0-100, making it easier to interpret than just trend direction alone. It compares favorably to other popular trend indicators like MACD and RSI.

What ADX period is best?

A period of 14 is most commonly used, matching the standard settings. Shorter periods capture more noise while longer periods are slower to react. 14 periods balances sensitivity and smoothing well.

How do I optimize ADX settings?

You can experiment with different ADX periods or apply a faster/slower smoothing to the calculations. Also consider adjusting buy/sell signal thresholds to suit your market or strategy. Backtesting can help optimize settings.

Why do ADX signals lag price?

As an indicator, ADX intentionally lags price action to filter out short-term volatility and clearly identify established trends. This lag can be advantageous for trend-following but reduces sensitivity to reversals.

How do I use ADX with other indicators?

Combining ADX signals with complementary indicators like moving averages, RSI, or MACD can help confirm trends and generate robust trading signals. Using multiple timeframes also enhances ADX analysis.

What causes false ADX signals?

Choppy, non-trending markets or periods of high volatility and news events tend to generate more false signals on the ADX. It works best in strongly trending environments.

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