Detecting a strong directional move is one of the essential skills every trader needs to master. Regardless of your strategy, finding a strong trend after you enter a position is essential. Created by legendary trader ‘Welles Wilder’ in 1978, the Average Directional Index (ADX) is a technical indicator widely used to identify strong trends and their direction. This article explains why ADX Indicator is so popular with traders at all levels in detail.
Forex Trading with ADX Indicator: Key Takeaways Here are a few ways that Forex traders can benefit from using the ADX Indicator: 1. ADX helps you identify trends: ADX is a trend-following indicator, so it can assist you in determining whether a currency pair is trending or not. 2. ADX tells you when to enter and exit trades: When the ADX is above 25, it is time to enter the trend. Traders should avoid entering trades in range-bound or weak markets (below 20). 3. ADX helps you set stop loss orders: By measuring trend strength, the ADX can help you determine where to place stop losses. 4. ADX helps you confirm other signals: By combining the ADX with other technical indicators, you can confirm or invalidate signals.
What is ADX Indicator?
The Average Directional Index (or ADX indicator) is a technical analysis tool used to determine the strength of a market trend by calculating its index. The ADX indicator can be used for a variety of trading purposes, such as estimating trend strength, detecting trends and ranges, and filtering different Forex trading strategies. Furthermore, the ADX indicator can be used for all types of trading vehicles, including stocks, mutual funds, ETFs, and futures.
The Average Directional Index, or ADX for short, can be considered an oscillator as well. In general, the ADX value fluctuates from 0 to 100, with low readings indicating a weak trend and high readings indicating a strong trend. While there are many ways to calculate ADX, in a nutshell, the stronger the trend, the higher ADX.
- If the ADX is low, it usually indicates times when the price oscillates or trades sideways.
- If the ADX rises above 50, this indicates that the price is picking up momentum.
Unlike Stochastic, ADX is not a trend-tracking indicator that identifies when there is a bullish or bearish trend. It simply measures how strong the current trend is compared with the trend of the past. As a result, ADX is typically used to determine whether the market is ranging or entering a new trend.
It does not matter if it is an uptrend or downtrend, the higher the reading, the stronger the trend!
Indicators such as ADX are non-directional. In this indicator, the highs and lows of bars are compared, and the closing price is not taken into consideration. The ADX Indicator is often used in combination with other technical indicators, notably the Moving Average Convergence Divergence (MACD) Or the Relative Strength Index (RSI), as a way of confirming the strength and direction of a trend.
ADX Indicator Calculation Explained
The ADX indicator is calculated using three components:
- The +DI (green line) represents a positive directional indicator
- The –DI (red line) represents a negative directional indicator.
- The ADX (black line) represents a non-directional indicator (which is essentially the difference between +DI and –DI) ranging from 0 to 100 with no negative values.
These lines are calculated using the formulas below.
- +DI = ((Smoothed MA + DM)/ATR) * 100
- -DI = ((Smoothed MA – DM)/ATR) * 100
- DX = ((+DI – -DI)/ (+DI + -DI)) * 100
- First ADX = sum n periods of DX / n
- After that ADX = ((Prior ADX * n-1) + Current DX) /n
+DM = Current High – Previous High
-DM = Previous Low – Current Low
ATR = Average True Range value
N = Number of periods used for calculation (by default, 14 periods are used, but traders can adjust it to suit their needs)
The good news for traders is that modern trading software makes these calculations for them automatically, and it is easy to use and intuitive. It is not necessary to download a separate ADX indicator for MetaTrader 4 since the ADX indicator is already included in the platform.
How to Read the Average Directional Index (ADX Indicator)
To read the Average Directional Index (ADX), you will need to plot the ADX line, as well as the positive directional index (DI+) and negative directional index (DI-), on a chart.
Here’s a chart Welles provided to help you read ADX trend strength.
|Non-trending market or range-bound market
|Very strong trend
|Extremely strong trend (rarely happens and may not be sustainable)
It is possible to determine the trend direction by observing the +DI and -DI lines. When the +DI is higher than the -DI, there is an uptrend; when the -DI is higher than the +DI, there is a downtrend. Crossings between +DI and -DI indicate a trend reversal. If +DI crosses above -DI, the trend is turning bullish; similarly, if -DI crosses above +DI, the trend is turning bearish. When a cross occurs along with an upward-moving ADX line, it gives the impression that the trend is especially strong.
It is important to note that the ADX is a lagging indicator, which means that it is based on past price action and may not accurately predict future price movements. As such, it is often used in conjunction with other technical indicators to confirm trend strength and direction.
Role of ADX Indicator in Forex Trading
The average directional index (ADX) has earned its place as one of the most important indicators used in analytical trading strategies for over 40 years. When it comes to forex trading, there is ample logic behind the rhyme “The trend is your friend.” Trading in the direction of a strong trend helps to minimize your risks, while also increasing your chances of making significant profits.
The ADX Indicator can be used to improve Forex trading in several ways:
1. Identifying Trend Strength
Wilder’s ADX directional movement index measures changes in market sentiment based on price fluctuations. By reading the ADX line, traders identify the strength of a trend and determine whether it is worth entering a trade. A reading above 20 indicates a strong trend, while a reading below 20 indicates a weak trend.
Forex traders have the option of manually adding trend levels to their indicator properties. The ADX indicator is as easy to use as clicking the button in MT4 as shown in the screenshot below:
2. Confirming Trend Direction
The direction of the positive directional index (DI+) and negative directional index (DI-) can be used to confirm the direction of a trend. If the DI+ is above the DI-, this may indicate an uptrend, while if the DI- is above the DI+, this may indicate a downtrend.
When the ADX line rises, it indicates that the trend is strengthening, so you should trade in the direction of the highest DI line. An upward slope of the blue line indicates that a bullish trend is dominating, and vice versa. In this way, you are able to measure both the strength and direction of a trend with the ADX Indicator.
3. Identifying Potential Trend Reversals
To identify potential trend reversals using the Average Directional Index (ADX), you will need to plot the ADX line on a chart. A reading below 50 on the ADX may indicate a potential trend reversal. This can be a helpful signal for traders looking to enter a trade in the opposite direction of the current trend.
If the ADX is trending lower while price action is trending higher, this may indicate a potential trend reversal. And if the direction of the DI+ and DI- changes, this may also indicate a potential trend reversal. The ADX line may also indicate a trend reversal if it breaks through a trendline that has been in place for an extended period of time.
4. Improving Trade Management
The Average Directional Index (ADX) can be used to improve trade management by helping traders adjust their stop-loss and take-profit orders according to the strength of the trend. If the ADX is indicating a strong trend, it may be wise to use a wider stop-loss to give the trade more room to move. This can help reduce the likelihood of being stopped out prematurely.
If the ADX is indicating a weak trend, it may be wise to use a tighter stop-loss to minimize potential losses. If the ADX is indicating a strong trend, traders may consider using a larger take-profit order to capitalize on the trend. In weaker trends, it may be wise to use a smaller take-profit order.
Overall, the ADX can be a valuable tool for Forex traders looking to improve their trading strategies and make more informed decisions.
Trading ADX Signals:
The ADX Indicator delivers several price signals that can be traded in the market. Learning how to trade the ADX signals can improve your trading accuracy. A few examples of these signals are:
Trading qualified opportunities in trending markets is the main goal of using the ADX Indicator. Therefore, you should be on the lookout for crossovers between the +DI and –DI lines. Whenever the +DI crosses above the -DI line, it indicates that positive price change exceeds negative price change in the market. The ADX above 25 is a solid signal to purchase when this happens.
A crossing of the -DI line over the +DI line indicates that negative price changes in the market are greater than positive price changes. This is a solid signal to place a sell order if the ADX is below 25. Trade entry and exit are both triggered by crossovers. Using trailing stops or exiting your trade position entirely can protect your capital if the –DI line crosses above +DI while you are in a long position.
Markets rely on the ADX to find ranges. When the ADX reading falls below 25 and stays there for a long time, it indicates that the market is trendless or basically rangebound. Markets that range is characterized by price bounces off recognizable support and resistance levels. A buy order is placed off a support area, whereas a sell order is placed off a resistance area in such markets.
It is inevitable that a range-bound market will eventually break out. Market breakouts frequently occur, and traders can take advantage of them. Despite the fact that breakouts can easily be identified, determining whether they are valid can be challenging. The number of fake breakouts is far too high, which can literally trap traders.
Validating breakouts is made easier by the ADX. The ADX reading above 25 indicates that momentum can be maintained in the new direction when the price breaks out. There is, however, the potential for an unsustainable breakout if the ADX reading is below 25.
Best ADX Indicator Combinations for Forex Trading
There are several technical indicators that can be used in combination with the Average Directional Index (ADX) to improve your forex trading performance. When paired with MACD, RSI, and Stochastic Oscillator, they produce higher probability trading signals.
ADX and Moving Average Convergence Divergence (MACD)
The MACD is a momentum indicator that can be used to determine trend direction, its strength as well as a possible reversal. MACD and ADX work best together when detecting reversals. A positive MACD crossover occurs when the MACD line crosses above the signal line. This may indicate a potential trend reversal and a buy signal.
An indication to buy can be identified when the MACD rises above zero, the ADX rises above 20 and the +DI line crosses above the -DI line. Similarly, a signal to sell will be triggered if the MACD falls below zero, the ADX rises above 20, and the -DI line crosses over above the +DI line, thus triggering a sell signal.
ADX and Relative Strength Index (RSI)
The RSI is a momentum indicator that measures the speed and change of price movements. When used in combination with the ADX, the RSI can help traders identify overbought and oversold conditions and confirm trend strength.
RSI readings above 70 indicate overbought conditions, while RSI readings below 30 indicate oversold conditions. When the ADX reading is below 25, and the RSI is oversold, it is time to buy in a range market. Similarly, sell orders can be placed when the price is edging higher, the ADX is below 25, and the RSI is overbought.
ADX and Stochastic Oscillator
The Stochastic Oscillator is a momentum indicator that measures the relationship between the closing price and the price range over a set period of time. When used in combination with the ADX, the Stochastic Oscillator can help traders identify potential trend reversals and confirm trend strength.
For example, if the ADX is above 20, this may indicate a strong trend. If the Stochastic Oscillator is showing a potential trend reversal, traders may consider waiting for the ADX to confirm the trend strength before entering a trade. Overbought markets and trend reversals may be indicated by the Stochastic Oscillator above 80. Stochastic Oscillators below 20 may indicate an oversold market and a potential trend reversal.
ADX and Parabolic SAR Indicator
Parabolic SAR is one of the leading trend-following indicators, and when combined with ADX, it can help traders maximize returns. In a trending market, Parabolic SAR can be used to enter early if three consecutive parabolas are printed in its direction. ADX crossovers can take some time to form in the market, and traders can enter a trending market early with Parabolic SAR.
In a similar manner, Parabolic SAR can identify an early exit signal if the parabolas flip onto the opposite side of the trend. It is possible to use this instead of waiting for the +DI and -DI crossovers.
Limitations of Using ADX Indicator in Forex Trading
While the Average Directional Index (ADX) can be a valuable tool for Forex traders, it is important to understand that it has certain limitations. Some of the limitations of using the ADX indicator include:
- It is a lagging indicator: The ADX is a lagging indicator, which means that it is based on past price action and may not accurately predict future price movements. As such, it should not be used as the sole source of information for making trading decisions.
- It does not indicate direction: The ADX only indicates the strength of a trend, it doesn’t indicate the direction of the trend. Traders need to use other indicators or chart patterns to determine the direction of the trend.
- It gives false signals: ADX can give false signals in choppy markets when the price moves in a sideways pattern without a clear trend. Traders need to be careful about interpreting signals in these conditions.
- Limited scope: ADX is mostly used for trending markets, it is not as useful in non-trending market conditions.
- It requires interpretation: The ADX is not a clear buy or sell signal and requires interpretation. Traders need to have a good understanding of the indicator to use it effectively.
It’s important to keep these limitations in mind when using the ADX in Forex trading and to use it in conjunction with other technical indicators and fundamental analysis to make informed trading decisions.
Try out different Forex indicators on a Demo account
Many market participants believe demo accounts are only suitable for beginners in the Forex market. While the truth is that a forex demo account allows beginners to learn the market for free, demo accounts are also ideal for exploring and experimenting with new forex brokers, platforms, and strategies.
This is because trading on a demo account mirrors real-world forex trading. Demo accounts allow users to experiment with real-world trading functions such as analyzing price movements, testing risk management strategies, understanding spreads, and utilizing stop-loss and take-profit orders.
A demo account is the best forex account for everyone who wants to explore the forex market and its conditions in a risk-free environment.
ADX Indicator (Average Directional Index) – FAQ
What is the ADX indicator and how does it work?
The ADX, or Average Directional Index, is a trend strength indicator that measures the strength of a trend in the market. The index compares two moving averages: the positive directional index (DI+) and the negative directional index (DI-). A reading above 20 on the ADX line indicates a strong trend, while a reading below 20 indicates a weak trend. Trend direction can be determined by the DI+ and DI- lines, while a reading below 50 on ADX may indicate a reversal of trend.
Is ADX Indicator good for intraday trading?
Yes, using an ADX indicator may prove useful for intraday traders since it can confirm whether a trend will continue or not. However, since the intraday market often experiences choppy and sideways movements, ADX signals may get less accurate in those scenarios. It’s always best to use multiple indicators together in order to get a better understanding of market conditions and to confirm signals.
How does the ADX indicator work in Forex Trading?
When it comes to forex trading, it makes good sense to say that “the trend is your friend” and that’s exactly the task the ADX indicator performs. ADX indicator helps determine the strength of a market trend, set stop-loss, identify potential trend changes, and help traders know when to enter and exit the trades with precision. Moreover, strong trends make it easier for you to make significant profits.
How can I confirm ADX signals with other technical indicators?
You can confirm ADX signals with other technical indicators by using them in conjunction with the ADX. For example, trend-following indicators like moving averages, or momentum indicators like RSI and MACD, with ADX can help you confirm trend strength and direction. Using volatility indicators such as Bollinger Bands, or other chart pattern recognition tools can be also useful in confirming ADX signals.
What is the best setting for ADX indicator?
The ADX indicator settings can vary depending on the trader’s preference and market conditions. The most commonly used setting for the ADX indicator is 14 periods. Traders may also choose shorter periods, such as 7 or 8, to make the indicator more responsive to short-term price movements, and others may prefer longer periods, such as 20 or 25, to make it more responsive to long-term trends.