What is ADX - Average Directional Index?
ADX is a lagging indicator that measures the trend strength without regard to trend direction.
ADX is formed by combining two other indicators which are positive directional indicator (abbreviated +DI) and negative directional indicator (abbreviated -DI). Positive Directional Indicator is calculated based on differences between current high and previous high over recent trading periods. Similarly Negative Directional Indicator is calculated based on differences between current low and previous low over certain recent trading periods.
ADX will range between 0 and 100 and is usually calculated based on 14 time-periods. Usually 20 is used as the key level for analysing ADX.
Since ADX enables one to quantify trend strength, it helps to identify the strongest trends as well as range conditions. So, appropriate trading strategy can be used. In trending conditions, one can enter on pullbacks and trade in direction of the trend where as in range conditions, one can trade on reversal either at support (bullish) or at resistance (bearish). In range conditions, another strategy can be to combine ADX with RSI (overbought and oversold) signal.
Different researchers have come out with various ways to interpret ADX. Some of the popular ones are as below:
- ADX below 20 indicates absence of trend and similarly ADX above 25 indicated strong trend. So, avoid trending strategies when ADX is below 20 as the market will be range bound and price action happens sideways.
- Increasing ADX values above 20, indicates increasing trend strength, thereby uptrending ADX confirms either bullish or bearish trends supporting decision to either buy or sell.
- ADX crossing over 25 from below especially after being below for 30 bars or so, indicates that price has broken out of range with sufficient strength and that now trend trading strategies can be profitably deployed.
- ADX above 50 indicates extremely strong trend.
- ADX value pulling back below 40 indicates trend getting exhausted and likely to reverse.
- ADX crossing below 20 from above especially after being above for 30 bars or so, indicates that market is likely to be rangebound and accordingly risk management strategies can be put in place to handle change in trend momentum.
- Trend is deemed to be uptrend when (+DI) line is above (-DI) line and ADX is above 20.
- Trend is deemed to be downtrend when (+DI) line is below (-DI) line and ADX is above 20.
- When ADX is above 20 and +DI line crosses over -DI line, buy signal is indicated.
- When ADX is above 20 and -DI line crosses over +DI line, sell signal is indicated.
Note: ADX or +DI/-DI based signals are frequently generated and have to be filtered, that is, they are to be confirmed using other indicators such as volume based indicators, basic trend analysis such as based on Moving Average (MA) Indicators and Chart patterns.