The Average Directional Index (ADX) is a unique tool used by traders globally to identify the strength of a trend in the financial market. Introduced by Welles Wilder in the mid-’70s, this game-changing setup seeks to quantify whether a financial asset is trending or not, regardless of its direction. This feature alone makes ADX a versatile tool for both newbies and experienced traders interested in forex, commodities, stocks, amongst others.
The beauty of the ADX setup lies in its simplicity and the valuable insights it provides into market trends. The ADX calculation is based on a moving average of price range expansion over a preset period, usually 14 bars. This calculation results in a value between 0 and 100 which indicates the strength of a trend. A higher value signals a stronger trend, whereas a lower value indicates a weaker trend or a trading range.
In the traditional interpretation of ADX, a value above 25 is considered a strong trend, and a value below 20 suggests a weak trend or a ranging market. However, it’s worth noting that this interpretation may vary depending on the market and trading style. Therefore, individual backtesting is recommended to determine optimal threshold levels for each specific case.
Additionally, the ADX methodology also includes two other lines – the positive directional indicator (+DI) and the negative directional indicator (-DI). The +DI measures the force of the upward moves, while the -DI quantifies the strength of the downward moves. They provide directional bias to the ADX strength reading – when +DI is above -DI, the prevailing trend is up, and vice versa.
One attractive setup that traders often use related to the ADX involves combining it with moving averages in a two-step pattern. The first step is to use the ADX to identify strong trends; then, the second step is to use moving averages for confirmation and precise entry points. For instance, in an uptrend identified by ADX, traders may then look for price to cross above a moving average as an entry point.
Also, because the ADX helps interpret the overall strength or momentum of a trend rather than its direction, it’s often paired other technical indicators. For instance, you may combine ADX with the Relative Strength Index (RSI) where the ADX helps monitor trend strength, and the RSI monitors if the market is overbought or oversold.
Remember that while an ADX reading above 25 suggests a strong trend, it doesn