Average Directional Index (ADX) is best known as the trend strength indicator. From just this sentence, you can understand that it is used to determine strong trends in prices. Trading in the direction of a strong trend helps traders to limit risks and increase chances of potential profits. After all, we must all remember that the trend is your friend and you should not go against it. If you are a beginner and this is the first time you hear this, well be sure to remember this sentence in every trading session.
The indicator works as an average of expanding price range values. This price range is based on the moving average. The setting for the period of time to be used is 14, however other time periods can also be used. The indicator can be used on any kind of security, whether it’s stocks, mutual funds, futures, exchanged traded funds or indices.
It is also a component of the Directional Movement System that was developed by Welles Wilder. Overall, the system aims to measure the strength of price movement in positive and negative directions. It uses DMI+ for positive and DMI- for negative directions as indicators along with the ADX. It is plotted on the graph in a line with different values ranging from zero to as high as 100.
In the chart above you can see, how the ADX is illustrated and plotted on a graph.
When the DMI+ is above the DMI- it means that the price is moving upwards and that the ADX is reading/measuring the strength of the uptrend. When the DMI- is above the DMI+ it means that the price is moving downwards and that it is reading/measuring the strength of the downtrend.
Key points:
ADX is a good indicator when it comes to guiding traders in identifying the strongest trend that can be the most profitable one. The values are not just important to measure the strength of the trend but to also distinguish if there is a trend or not. The most common value traders will take as an indicator is 25. For example, if its value is above 25 there is a strong trend and if it is below the 25 level the trend is weak. When the trend is weak traders will take a step back and will probably avoid the specific trade.
Price is the most important thing on a chart. Before considering having a look at the ADX you should first read the price and then apply the ADX. When traders use indicators, it is because the price can not show something more than just the price which is why they seek indicators. For example, the best trends are happening when the price range consolidation is happening. On the other hand, breakouts from a range occur when both buyers and sellers, switch the supply and demand. This means that if for example, the buyers were in control, meaning the price was going up and then sellers gained control the supply and demand was shifted from the buyers to the sellers. This difference is the main “creation” of price momentum.
Breakouts can many times be fake breakouts and fail to progress in the predicted direction. However, ADX is used to avoid such mistakes by showing valid trends, with the values of strong, very strong, extremely strong. However, I personally believe that the most important part of the ADX is the ability to distinguish non-trends from trends before getting trapped.
A continuous peak in ADX values can also be a representation of overall trend momentum. ADX is an indicator for trend momentum, or in other words the speed that the price is moving. Price momentum is increasing when a continuous spike of ADX highs appears and vice versa.
Note: In an uptrend, the price can still be higher on decreasing ADX momentum while the trend is progressing.
The hardest thing to spot on price movements is when they turn from being a trend to being in range conditions. Even if the ADX can show when the trend is weakening and is entering the range consolidation these range conditions exist when the ADX goes from above 25 to below 25. Meaning that until then this is the weak spot. In a range, the trend is sideways, and the price movement and trend are difficult to spot. ADX will move sideways along with the trend until the balance of supply and demand or buyers and sellers change again and becomes clearer.
Trading in the direction of a strong trend brings the best profits and avoids range conditions. Since the trend is your friend you should never go against it! The ability to identify the trend’s strength is a golden pass for traders. ADX can also show the range conditions when a sideways trend exists and help traders to prevent being stuck in such price action. The change in momentum is also important for traders to make appropriate risk management. Overall, ADX can be extremely helpful and is fully recommended to every trader no matter the level of experience.
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