ADX indicator

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ADX: The Trend Strength Indicator

Trading in the direction of a strong trend reduces risk and increases profit potential. The average directional index (ADX) is used to determine when the price is trending strongly. In many cases, it is the ultimate trend indicator. After all, the trend may be your friend, but it sure helps to know who your friends are. In this article, we’ll examine the value of ADX as a trend strength indicator.

Introduction to ADX

ADX is used to quantify trend strength. ADX calculations are based on a moving average of price range expansion over a given period of time. The default setting is 14 bars, although other time periods can be used.   ADX can be used on any trading vehicle such as stocks, mutual funds, exchange-traded funds and futures.

ADX is plotted as a single line with values ranging from a low of zero to a high of 100. ADX is non-directional; it registers trend strength whether price is trending up or down.   The indicator is usually plotted in the same window as the two directional movement indicator (DMI) lines, from which ADX is derived (Figure 1).

For the remainder of this article, ADX will be shown separately on the charts for educational purposes.

Source: TDAmeritrade Strategy Desk

Figure 1: ADX is non-directional and quantifies trend strength by rising in both uptrends and downtrends.

When the +DMI is above the -DMI, prices are moving up, and ADX measures the strength of the uptrend. When the -DMI is above the +DMI, prices are moving down, and ADX measures the strength of the downtrend. Figure 1 is an example of an uptrend reversing to a downtrend. Notice how ADX rose during the uptrend, when +DMI was above -DMI. When price reversed, the -DMI crossed above the +DMI, and ADX rose again to measure the strength of the downtrend.

Quantifying Trend Strength

ADX values help traders identify the strongest and most profitable trends to trade. The values are also important for distinguishing between trending and non-trending conditions. Many traders will use ADX readings above 25 to suggest that the trend is strong enough for trend-trading strategies. Conversely, when ADX is below 25, many will avoid trend-trading strategies.

ADX Value Trend Strength
0-25 Absent or Weak Trend
25-50 Strong Trend
50-75 Very Strong Trend
75-100 Extremely Strong Trend

Low ADX is usually a sign of accumulation or distribution.   When ADX is below 25 for more than 30 bars, price enters range conditions, and price patterns are often easier to identify. Price then moves up and down between resistance and support to find selling and buying interest, respectively. From low ADX conditions, price will eventually break out into a trend. In Figure 2, price moves from a low ADX price channel to an uptrend with strong ADX.

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Source: TDAmeritrade Strategy Desk

Figure 2: When ADX is below 25, price enters a range. When ADX rises above 25, price tends to trend.

Source: TDAmeritrade Strategy Desk

Figure 3: Periods of low ADX lead to price patterns. This chart shows a cup and handle formation that starts an uptrend when ADX rises above 25.

The direction of the ADX line is important for reading trend strength. When the ADX line is rising, trend strength is increasing, and the price moves in the direction of the trend. When the line is falling, trend strength is decreasing, and the price enters a period of retracement or consolidation.

A common misperception is that a falling ADX line means the trend is reversing. A falling ADX line only means that the trend strength is weakening, but it usually does not mean the trend is reversing, unless there has been a price climax. As long as ADX is above 25, it is best to think of a falling ADX line as simply less strong (Figure 4).

Source: TDAmeritrade Strategy Desk

Figure 4: When ADX is below 25, the trend is weak. When ADX is above 25 and rising, the trend is strong. When ADX is above 25 and falling, the trend is less strong.

Trend Momentum

The series of ADX peaks are also a visual representation of overall trend momentum. ADX clearly indicates when the trend is gaining or losing momentum. Momentum is the velocity of price. A series of higher ADX peaks means trend momentum is increasing. A series of lower ADX peaks means trend momentum is decreasing. Any ADX peak above 25 is considered strong, even if it is a lower peak. In an uptrend, price can still rise on decreasing ADX momentum because overhead supply is eaten up as the trend progresses (Figure 5).

Source: TDAmeritrade Strategy Desk

Figure 5: ADX peaks are above 25 but getting smaller. The trend is losing momentum but the uptrend remains intact.

Knowing when trend momentum is increasing gives the trader confidence to let profits run instead of exiting before the trend has ended. However, a series of lower ADX peaks is a warning to watch price and manage risk. The best trading decisions are made on objective signals, not emotion.

ADX can also show momentum divergence. When price makes a higher high and ADX makes a lower high, there is negative divergence, or non-confirmation. In general, divergence is not a signal for a reversal, but rather a warning that trend momentum is changing. It may be appropriate to tighten the stop-loss or take partial profits.

Any time the trend changes character, it is time to assess and/or manage risk. Divergence can lead to trend continuation, consolidation, correction or reversal (Figure 6).

Source: TDAmeritrade Strategy Desk

Figure 6: Price makes a higher high while ADX makes a lower high. In this case, the negative divergence led to a trend reversal.

Strategic Use of ADX

Price is the single most important signal on a chart. Read price first, and then read ADX in the context of what price is doing. When any indicator is used, it should add something that price alone cannot easily tell us. For example, the best trends rise out of periods of price range consolidation. Breakouts from a range occur when there is a disagreement between the buyers and sellers on price, which tips the balance of supply and demand. Whether it is more supply than demand, or more demand than supply, it is the difference that creates price momentum.

Breakouts are not hard to spot, but they often fail to progress or end up being a trap. However, ADX tells you when breakouts are valid by showing when ADX is strong enough for price to trend after the breakout. When ADX rises from below 25 to above 25, price is strong enough to continue in the direction of the breakout.

ADX as a Range Finder

Conversely, it is often hard to see when price moves from trend to range conditions. ADX shows when the trend has weakened and is entering a period of range consolidation. Range conditions exist when ADX drops from above 25 to below 25. In a range, the trend is sideways, and there is general price agreement between the buyers and sellers. ADX will meander sideways under 25 until the balance of supply and demand changes again.

ADX gives great strategy signals when combined with price. First, use ADX to determine whether prices are trending or non-trending, and then choose the appropriate trading strategy for the condition. In trending conditions, entries are made on pullbacks and taken in the direction of the trend. In range conditions, trend-trading strategies are not appropriate. However, trades can be made on reversals at support (long) and resistance (short).

The best profits come from trading the strongest trends and avoiding range conditions. ADX not only identifies trending conditions, it helps the trader find the strongest trends to trade. The ability to quantify trend strength is a major edge for traders. ADX also identifies range conditions, so a trader won’t get stuck trying to trend trade in sideways price action. In addition, it shows when price has broken out of a range with sufficient strength to use trend-trading strategies. ADX also alerts the trader to changes in trend momentum, so risk management can be addressed. If you want the trend to be your friend, you’d better not let ADX become a stranger.

Average Directional Index – ADX Definition and Uses

What is the Average Directional Index (ADX)?

The average directional index (ADX) is a technical analysis indicator used by some traders to determine the strength of a trend. The trend can be either up or down, and this is shown by two accompanying indicators, the Negative Directional Indicator (-DI) and the Positive Directional Indicator (+DI). Therefore, ADX commonly includes three separate lines. These are used to help assess whether a trade should be taken long or short, or if a trade should be taken at all.

Key Takeaways

  • Designed by Welles Wilder for commodity daily charts, but can be used in other markets or other timeframes.
  • The price is moving up when +DI is above -DI, and the price is moving down when -DI is above +DI.
  • Crosses between +DI and -DI are potential trading signals as bears or bulls gain the upper hand.
  • The trend has strength when ADX is above 25. The trend is weak or the price is trendless when ADX is below 20, according to Wilder.
  • Non-trending doesn’t mean the price isn’t moving. It may not be, but the price could also be making a trend change or is too volatile for a clear direction to be present.

The Formulas for the Average Directional Index

(ADX) Indicator are

The ADX requires a sequence of calculations due to the multiple lines in the indicator.

Calculating the Average Directional Movement Index (ADX)

  1. Calculate +DM, -DM, and True Range (TR) for each period. 14 periods are typically used.
  2. +DM = Current High – Previous High.
  3. -DM = Previous Low – Current Low.
  4. Use +DM when Current High – Previous High > Previous Low – Current Low. Use -DM when Previous Low – Current Low > Current High – Previous High.
  5. TR is the greater of the Current High – Current Low, Current High – Previous Close, or Current Low – Previous Close.
  6. Smooth the 14-period averages of +DM, -DM, and TR. The TR formula is below. Insert the -DM and +DM values to calculate the smoothed averages of those.
  7. First 14TR = Sum of first 14 TR readings.
  8. Next 14TR value = First 14TR – (Prior 14TR/14) + Current TR
  9. Next, divide the smoothed +DM value by the smoothed TR value to get +DI. Multiply by 100.
  10. Divide the smoothed -DM value by the smoothed TR value to get-DI. Multiply by 100.
  11. The Directional Movement Index (DX) is +DI minus -DI, divided by the sum of +DI and -DI (all absolute values). Multiply by 100.
  12. To get the ADX, continue to calculate DX values for at least 14 periods. Then, smoothe the results to get ADX
  13. First ADX = sum 14 periods of DX / 14
  14. After that, ADX = ((Prior ADX * 13) + Current DX) /14

What Does the Average Directional Index (ADX) Tell You?

The Average Directional Index (ADX) along with the Negative Directional Indicator (-DI) and the Positive Directional Indicator (+DI) are momentum indicators. The ADX helps investors determine trend strength while -DI and +DI help determine trend direction.

The ADX identifies a strong trend when the ADX is over 25 and a weak trend when the ADX is below 20.

Crossovers of the -DI and +DI lines can be used to generate trade signals. For example, if the +DI line crosses above the -DI line and the ADX is above 20, or ideally above 25, then that is a potential signal to buy.

If the -DI crosses above the +DI, and ADX is above 20 or 25, then that is an opportunity to enter a potential short trade.

Crosses can also be used to exit current trades. For example, if long, exit when the -DI crosses above the +DI.

When ADX is below 20 the indicator is signaling that the price is trendless, and therefore may not be an ideal time to enter a trade.

The Difference Between Average Directional Index (ADX) and the Aroon Indicator

The ADX indicator is composed of a total of three lines. The Aroon Indicator is composed of two. The two indicators are similar in that they both have lines representing positive and negative movement, which helps to identify trend direction. The Aroon reading/level also helps determine trend strength, like the ADX does. The calculations are different though, so crossovers on each of the indicators will occur at different times.

Limitations of Using the Average Directional Index (ADX)

Crossovers can occur frequently. Sometimes too frequently, resulting in confusion and potentially lost money on trades that quickly go the other way. These are called false signals. This is more common when ADX values are below 25. That said, sometimes the ADX reaches above 25, but is only there temporarily and then reverses along with the price.

Like any indicator, the ADX should be combined with price analysis and potentially other indicators to help filter signals and control risk.

Average Directional Movement Index (ADX)

Description

ADX stands for Average Directional Movement Index and can be used to help measure the overall strength of a trend. The ADX indicator is an average of expanding price range values. The ADX is a component of the Directional Movement System developed by Welles Wilder. This system attempts to measure the strength of price movement in positive and negative direction using the DMI+ and DMI- indicators along with the ADX.

How this indicator works

  • Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below 20.
  • When the ADX turns down from high values, then the trend may be ending. You may want to do additional research to determine if closing open positions is appropriate for you.
  • If the ADX is declining, it could be an indication that the market is becoming less directional, and the current trend is weakening. You may want to avoid trading trend systems as the trend changes.
  • If after staying low for a lengthy time, the ADX rises by 4 or 5 units, (for example, from 15 to 20), it may be giving a signal to trade the current trend.
  • If the ADX is rising then the market is showing a strengthening trend. The value of the ADX is proportional to the slope of the trend. The slope of the ADX line is proportional to the acceleration of the price movement (changing trend slope). If the trend is a constant slope then the ADX value tends to flatten out.

Calculation

ADX is simply the mean, or average, of the values of the DX over the specified Period.

DMI assists in determining if a security is trending and attempts to measure the strength of the trend.

Technical analysis focuses on market action — specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you’re most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation. Past performance is no guarantee of future results.

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