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Average Directional Index (ADX)

What is the Average Directional Index?

The Average Directional Index (ADX) is a lagging trend indicator that indicates the strength of a trend. In other words, it measures when a security is in a strong uptrend or downtrend, or whether it is moving sideways in a trading range rather than a trend. It was designed by John Welles Wilder, Jr. as part of an indicator system that Wilder called the Directional Movement Index (DMI). The DMI, which was first revealed in Wells Wilder's book, New Concepts in Technical Trading Systems of 1978, consists of three lines: the +DI line, the -DI line and ADX line, though the ADX can be used on its own, and on any trading timeframe, to help identify potential turning points on the price chart of the underlying security.

The Average Directional Index (ADX) is also related to Wilder's Average True Range (ATR), to the extent that the ATR is used in the computation of the ADX.

The ADX is an oscillator that fluctuates between 0 and 100, with values above 25 generally indicating a strong, sustainable trend and values below 20 indicating a weak trend or a flat trading range. However, the ADX is not concerned with the direction of the trend and does not indicate whether the trend is a bullish uptrend or a bearish downtrend. It merely indicates the strength of the current trend. For the ADX, a value above 25 can indicate a strong uptrend as well as a strong downtrend, in other words, a value above 25 indicates that a strong trend has been established, and the trend is sufficiently strong to continue on its current trajectory. However, extremely values (above 75) indicate overbought and oversold conditions that suggest the current trend should run out of steam and would most likely be coming to an end very soon.

The ADX does not give entry or exit signals. It does, however, give some perspective as to whether the security is in a tradable trend, which can be quite useful to traders who implement, or plan to implement, tend-following trading strategies.

How to calculate the ADX Indicator?

Average Directional Index (ADX) has a fairly complicated calculation that consists of the following five steps.

First, the Directional Movement (DM) is calculated in both the positive (+DM) and the negative (-DM) directions. +DM is the difference between the current high and the previous high; while the -DM is the difference between the current low and the previous low.

+DM = Current High − Previous High

-DM = Previous Low − Current Low

When both the +DM as well as the -DM are positive, the larger of the two values is used and the smaller value is set to 0.

Next, the True Range (TR) is calculated. The True Range (TR) normalizes the price movement by taking into account any gaps in price movement. The True Range (TR) is the greatest of the following three values:

Current High − Current Low

Current High − Previous Close

Current Low − Previous Close

Then, both the +DM and the -DM are smoothed using Wilder's Smoothed Moving Average (WSMA) as well as Wilder's Average True Range (ATR) over a specified look-back period, with 14 being the default period. This produces the Smoothed Directional Movement Indicators (+DI and -DI). The formula for the smoothing is as follows:

+DI = (Smoothed +DM ÷ ATR) × 100

-DI = (Smoothed -DI ÷ ATR) × 100

In the fourth step, the +DM and the -DM are transformed into the Directional Movement Index (DX) by calculating the absolute difference between +DI and -DI, relative to their sum. In mathematics, the absolute value of a real number is the (non-negative) magnitude of that number regardless if it is positive or negative. The absolute value of a number is denoted by two vertical pipes surrounding the number, such as |x|. The formula is as follows:

DX = ( | +DI − -DI | ÷ | +DI + -DI | ) × 100

Finally, the Average Directional Index (ADX) is calculated by smoothing the DX using Wilder's Smoothed Moving Average (WSMA) over a specified look-back period. The formula for the smoothing is as follows:

ADX = (Previous ADX × (n-1) + Current DX) ÷ n

where n is the specified look-back period.

How to trade with the ADX Indicator?

The ADX indicator does not generate trade entry and exit signals. Furthermore, the ADX indicates the strength of a trend but not the direction of the trend.

ADX values above 25 indicate that a strong trend has emerged, regardless of whether the trend is a bullish uptrend or a bearish downtrend. This lack of trend direction is a result of the ADX using absolute (non-negative) values in its calculation. Essentially, the ADX is the absolute difference between the +DI line and the -DI line. The direction of the trend can be determined by the position of the +DI and -DI lines. When the +DI is above the -DI line, the trend is bullish; and when the -DI is above the +DI line, the trend is bearish.

Thus, the ADX is best used to determine the strength of a trend, making it a valuable tool for traders who implement trend-following strategies.

Trend Strength

Range-bound or Weak Trend

Generally, when the ADX is below 20 it indicates that the stock being analyzed is range-bound, i.e., it is trading in a sideways range. This is usually a sign of accumulation or distribution, especially when the ADX remains below the 20 line for more than 30 periods. Under these conditions, trend-following trading strategies cannot be implemented as there is no real trend to speak of but, an oscillator indicator, such as the Stochastic Oscillator, can be used to analyze the security. In addition, chart patterns also become easier to identify and can be used for entry and exit signals.

Strong Trend

When the ADX values move above the 25 line, it indicates that a trend has been established, and when the ADX values move above 30, it indicates that the trend is strong and has enough momentum to continue on its current trajectory. However, when the ADX values are above 75, it indicates overbought and oversold conditions, which suggest that the current trend could be running out of momentum and would most probably weaken or reverse in the near future.

In a strong uptrend, long positions (buy orders) could be opened and held until one or more momentum indicators, such as the RSI or the CCI, indicate a weakening of the momentum behind the trend. Alternatively, in a strong downtrend, short positions (sell orders) could be opened and held until one or more momentum indicators indicate a weakening of the trend.

Directional Movement (DM) Crossover

The Directional Movement (DM) consists of the +DI and -DI lines. These lines can also generate trade signals when they crossover each other in a trending market, i.e., when the ADX values are above the 25 line and rising.

When the +DI line crosses above the -DI line, it generates a bullish signal that indicates that momentum is building on the side of the bulls and long positions should be sought. Conversely, when the -DI line crosses above the +DI line, it generates a bearish signal that indicates that momentum is building on the side of the bears, meaning short positions should be more profitable.

However, it is advisable that confirmation of these signals are acquired before entering a trade!

Divergence

The ADX indicator can also generate trade signals when its movement diverges from that of the price action of the underlying security.

Divergence occurs when the price action of the underlying security and the ADX are moving in opposite directions, and implies a fundamental weakness in the trend. This occurs, for example, when the price action is making higher highs and higher lows, but the ADX is making lower highs and lower lows. This indicates that the selling pressure (distribution) is gaining strength despite the uptrend, and the uptrend is unlikely to continue for much longer. Conversely, when the price action is making lower highs and lower lows, but the ADX is making higher highs and higher lows, it indicates that the buying pressure (accumulation) is gaining strength despite the downtrend and that the downtrend is unlikely to continue.

When divergence occurs between ADX and the price action, it provides an early signal that a trend reversal is probable. As a result, traders would no longer expect the price action to rebound back in the direction of the trend after a minor correction, instead traders would expect the current trend to either reverse or weaken into a sideways trading range. Under these conditions, traders would look to close out any open positions that they are holding.

Average Directional Index Trading Cheat Sheet

ADX Value	Trend Strength	Implications
Rising	Trend is strengthening	Trend is gaining momentum.
Falling	Trend is weakening	Trend is losing momentum.
Below 20	Weak trend or Range bound	Avoid range-bound markets. Wait for the trend to emerge.
Between 20 and 25	Trend is developing	Wait for confirmation of trades in the direction of the trend.
Above 25	Trend is strong	Trade in the direction of the trend.
Above 75	Trend is extremely strong.	Trade in the direction of the trend but be weary of Oversold and Overbought conditions.

Chart Example

The following chart shows a 13-period Wilder's DMI in the lower chart panel on a 30-minute chart of the Dow Jones Industrial Index. The green line is the ADX line while the blue line is the +DI line and the red line is the -DI line.

Advantages and Disadvantages of the ADX Indicator

ADX Frequently Asked Questions

What is the ADX?

The ADX is a technical indicator that measures the strength of a trend; thereby indicating when a security is in a strong trend or when it is moving sideways in a trading range rather than a trend.

Does the ADX indicate the direction of a trend?

No, the ADX measures the strength of the trend, regardless of the direction of the trend. However, the +DI and -DI lines can be used to determine whether the trend is bullish or bearish.

Can the ADX be used to trade ForEx?

Yes, the ADX can be used in any market, including the ForEx market. However, as the ForEx market often experiences long periods of ranging price action, it is advisable to use higher ADX thresholds (25-30) for determining the trend strength.

Is the ADX a leading or a lagging indicator?

The ADX is a lagging indicator that does not predict the price movements instead it reacts to price action.

Which indicators are best to use with the ADX indicator?

The ADX indicator is best paired with directional and momentum indicators, such as Moving Averages (MAs), RSI, and MACD. When used with Moving Averages, the MA can be used determine the direction of the trend while the ADX can be used to determine the strength of the trend. Thus, the ADX can be used to filter out MAs crossover signals when the ADX is below 25. Similarly, the ADX can be used to filter out MACD crossover signals when the ADX is below 25. Inversely, the RSI can filter out trade signals when the RSI indicates overbought and oversold conditions.

Summary

The ADX is a valuable, but lagging, technical indicator that measures the strength of a trend but not its direction. However, the +DI and -DI lines can be used to determine trend direction. The ADX is very useful in trend-following strategies where an ADX value above 25 indicates the presence of a strong trend. It is best used with other technical indicators, such as Moving Averages (MAs), RSI, MACD, and Parabolic SAR, to filter out potential false signals, and overcome some of the weaknesses and limitations of the ADX.