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Average Directional Movement Index (ADX): How this indicator can help you avoid the congestion
This oscillating indicator was introduced by J. Welles Wilder in 1978 as a measure of a market’s trendiness.
The purpose of average directional movement index is to help in finding out whether a market finds itself in trend (regardless if it’s bearish or bullish), with a values above 25 signaling a trending market and otherwise showing no trend.
A large number of traders are trend followers, despite the fact that markets only trend a very small portion of time.
Trend followers expect that by diversifying across multiple markets, they will ride several that sufficiently trend enough that they can make up for all of the other losing ones and still make enough money to provide a profitable year.
While long term trend followers only hope to capture a few trends a year, they are always anticipating that once-in-a-lifetime market rally.
These once-in-a-lifetime events do occur more frequently than one would expect, and most trend-following systems are more than capable of catching and riding it on for the long haul.
So what’s the problem?
The biggest issue with trend following is, of course, whipsaw trades, that you get into and very quickly get stopped out or reversed. Another common issue is lack of profit retention when the trend is over.
The purpose of average directional movement index is to save the day. This indicator tries to define the current market’s trendiness with just one simple value. The average directional movement index value is high when the market is trending and low when it is in congestion and therefore can help the trader time profitable exit points when holding a particular position.
What is the ADX?
The average directional movement index is a momentum indicator that attempts to assess the strength of a current trend and to measure the directional movement of price.
The key principle behind the calculation was that in the event of an up trend, a current day’s high would likely be higher than that of the previous trading day.
Conversely, in the event of the down trend, a current day’s low would likely be lower than that of the previous one.
The average directional movement index is a measure of the strength of a trend, be it upward or downward.
The ADX fluctuates between zero and 100, although values above 60 are rare. Values under 20 indicate a weak trend often seen as range trading. Values over 40 mean a powerful directional trend. Though the average directional movement index does not show the direction of a trend as long or short, a value over 40 clearly indicates there is strength in the current trend.
Put it this way.
If you find an instrument with a reading over 40, this would mean a strong trend but would not identify it as biased upward or downward.
The average directional movement index can be used to identify potential changes in a market from non-trending to trending.
How is this task accomplished?
The average directional movement index is also an indication of the strength of a trend — the higher the indicator, the more powerful is the trend.
Using the ADX, we can find out whether a trend is operative and decide whether to rely on momentum oscillators or use a trend-following approach.
The average directional movement index can also indicate that a strong trend is ending and it’s time to take your profits.
The basic theory behind the ADX
The average directional movement index is based on market directional movement.
This movement can be characterized as either positive, negative, or neutral.
J. Welles Wilder designed average directional movement index to determine the presence of a trend in a given financial instrument.
So let’s take a closer look.
The ADX is made of three lines: the index itself and two other lines known as the directional movement indicators (DMIs), also devised by Wilder. One of the lines is known as +DI (Positive Directional Indicator) while the other is –DI (Negative Directional Indicator), indicating positive and negative directions.
The average directional movement index provides an objective measure of the strength of a trend.
It is non-directional and related to the respective directional indicator, so it will provide a measure of the strength of the particular direction.
When it rises, the trend signaled by the directional indicator crossing above the other line is expected to be stronger; when it falls, the weaker trend is anticipated.
DMI—Directional Movement Indicator
Also designed by J. Welles Wilder, the Directional Movement Indicator (DMI) used to determine if the market is “trending” or “not trending.”
The indicator has three components: the +DI, the -DI, and the ADX.
It is suggested to buy when the Positive Directional Indicator (+DI) crosses above the –DI, or sell short when the +DI crosses below the –DI.
The average directional movement index is a smoothed derivative version of the directional movement indicator.
It is a measure of the strength of a trend, as opposed to direction: Higher ADX values suggest more “directional” market; Lower ADX values signal less “directional” market.
Here’s the thing.
The average directional movement index does not tell us whether the market is bullish or bearish.
The Overbought and Oversold conditions reflect the strength or weakness of the trend, rather than the market itself.
The DMI values range from 0 to 100. It is composed of two lines, the DI and the DI (positive and negative directions).
The ADX represents a moving average of the DMI.
Its value starts with 25 for a trend to have the required strength for its definition.
Instead of using the closing price for each bar as an input, DMI uses each bar’s net directional move.
Net directional movement is defined as the largest part of a period’s range that is outside of the previous bar’s range and includes separate calculations for positive movement (+DI) and negative movement (–DI).
+DI (Positive Directional Indicator).
The DI is an element of the average directional movement index that is used to measure an uptrend.
When the DI slopes upward, it indicated that the uptrend is gaining strength.
+DI crossing above the negative directional indicator (-DI) indicates the beginning of the uptrend.
-DI (Negative Directional Indicator).
The DI is another element of the average directional movement index that is used to indicate a downtrend.
When the slope of the -DI starts rising, it signals that the downtrend is gaining strength.
When it crosses above the DI, this indicates the beginning of a new downtrend.
If the +DI is greater than the –DI, the indicator suggests a bullish trend.
if –DI is greater than the +DI, then then the market is thought of as trending higher.
So what’s it all mean?
Since the market direction is defined by whether DMI is above or below the zero line, it is can be thought as another variation of stop and reverse trend-following system.
The basic rule for trading, while being short, is to note the high of the bar when the +DI crossed above the -DI, and both exit a short position and enter a long position on any subsequent bar when the price traded above the noted high.
For being long, the rule is to note the low of the day when the +DMI crossed below the -DMI, and both exit a long position and enter a short position on any subsequent day when the price traded below the noted low.
This rule set will always keep the trader in a position. These crossing are referred to as bullish / bearish crossings.
Using ADX to avoid sideways markets
The ADX is frequently used to avoid markets that are not trending, and indicates when a trend reaches a profitable trading level. In a trendless market, the ADX signals avoidance.
Directional movement is a measure of the net total price move occurred during a fixed period of time.
So let’s take a closer look.
First, the daily up and down moves are added to calculate the positive and negative directional movements. The results are then normalized by dividing them by the absolute value of the total movement for the same period.
The directional movement is expressed as a percentage and represents the difference between normalized values. The average directional movement index is then obtained from directional movement using exponential average and ratios.
How to trade the ADX: a simple rule
Traders who use ADX follow an uncomplicated rule:
A rise by the ADX line above 40 followed by a downturn indicates an imminent end to the current trend. Based on this observation, when the ADX line moves above 40 and then turns down, we should consider exit and taking a profit. It does not matter if the primary trend is up or down. The direction of the primary trend is irrelevant. As soon as the ADX line turns down, it’s an indication to exit and take a profit.
While the ADX can signal the end of the current trend, a reversal of the trend is not always the next step.
Instead, the market may enter a consolidation phase and move from left to right for a period of time.
The ADX is not useful during sideways markets.
One has to rely on other indicators for the possible direction of the next move.
The average directional movement index has become a popular tool used extensively to determine the trend with the following rules:
1) ADX rising above 25 indicates that the market is trending. 2) ADX falling below 20 signals the market consolidation. 3) If ADX falls below 45 after being higher, the market is consolidating. 4) ADX rising above 10 few bars after being lower indicates that the market is about to begin the new trend.
Try It Yourself
After all the sides of the indicator were revealed, it is right the time for you to try either it will become your tool #1 for trading.
In order to try the indicator performance alone or in the combination with other ones, you can use Forex Tester with the historical data that comes along with the program.
Simply download Forex Tester for free. In addition, you will receive 23 years of free historical data (easily downloadable straight from the software).
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