The Average Directional Index, or ADX indicator, is a technical tool designed to measure the strength of a market trend.
Some of the most powerful trading strategies revolve around following market trends. There are also strategies that seek to profit from the market, by trading counter to the trend. If you are able to correctly identify when a trend is forming, you will be stacking the odds into your favour.
Just as useful is the ability to gauge the strength of a trade. There are a variety of indicators that attempt to do this. The ADX indicator is one such tool. It was developed by J. Welles Wilder, who also invented other extremely popular technical indicators like RSI Indicator, ATR Indicator and Parabolic SAR Indicator.
If you haven't already looked at one of Wilder's indicators, be sure to check it out risk-free on our Demo Account.
The ADX indicator is used for different purposes:
The ADX technical indicator is derived from two of Wilder's directional indicators:
These indicators do the following:
They define directional movement by comparing the high and low of the current period with the high and low of the previous period. Wilder defined two terms that help here:
So when the +DM has a value other than zero, the -DM is zero. And when the -DM has a value other than zero, the +DM is zero. Directional movement is positive when:
Negative directional movement is defined in a similar way.
Directional movement is negative when the previous low minus the current low is both positive and greater in value than the previous high minus the current high.
When the +DMI is above the -DMI, prices are moving up and the ADX measures the strength of the uptrend. When the -DMI is above the +DMI, prices are moving down, and the ADX measures the strength of the downtrend.
For traders, the good news is that modern software does these calculations for you automatically.
The standard MetaTrader 4 platform comes with the ADX indicator, so there's no need for a separate ADX indicator download.
If you want to step your Forex & CFD trading up with a wider selection of indicators that can also complement the ADX, the innovative MetaTrader 4 Supreme Edition plug-in has you covered.
Once you have installed MetaTrader 4 on your device, you will see a much more advanced ADX technical indicator than what Wider originally proposed. This is because the MT4 ADX uses slightly different auto-smoothing techniques that give a more precise but less smooth graph.
The chart below shows the Average Directional Movement Index as the first item on the list of trend indicators. Just drag and drop it to the chart.
Source: EUR/USD H4 Chart, Admiral Markets Platform, Aug 14
If you select ADX, MT4 will prompt you to enter a value for the period. You can also change the colours in the indicator itself to match the colours displayed on the charts here. You can do that in the indicator properties.
Source: ADX Indicator, Admiral Markets MT4 Platform
The default value is 14, and the standard way of depicting ADX is to show three lines below the main price chart.
Source: EUR/USD H4 Chart, Admiral Markets Platform, Aug 14
These lines include a:
Software packages will usually plot values for +DI and -DI, alongside the value of the ADX.
By now, you hopefully understand that the advanced ADX indicator is used to show you whether or not the market is trending. But how do we know when a trend occurs?
Basically, the ADX ranges from 0 to 100.
Wilder considered a value:
But as you can see, these values leave you in limbo between 20 and 25. For this reason, many modern technical analysts use 25 as the key demarcation point between trend and no trend. Read further to get a deeper knowledge into the ADX indicator.
Wilder's ADX directional system can also gauge the change in market sentiment by tracking changes in the price range. By reading the ADX line, we can measure an underlying trend strength.
You can add these levels manually within the indicator properties.
Source: ADX indicator, Admiral Markets MT4 Platform
As we can see, the ADX shows when the trend has weakened and is entering a period of range consolidation. Range conditions exist when the ADX drops from above 25 to below 25.
We can also see two dotted lines. The blue (+DI) and the red (-DI). If the +DI line is above the -DI line, it suggests a bullish trend. Conversely, if the -DI line is above the +DI line, it suggests a bearish trend. The strength of that trend is reflected in the ADX line. Now, here's how Wilder suggests you interpret this indicator's info.
Wilder said that when the ADX line rises, it suggests the trend is strengthening, so you should trade in the direction of whichever DI line is higher. If the blue line is above the red line, it means that the bullish trend is dominating, and vice versa. Thus, with the ADX, you can measure both trend strength and trend direction. Take a look at the chart below.
Source: USD/CAD, Daily Chart, Admiral Markets MT4, Aug 16
The chart above shows a strong bullish daily trend.
The ADX can also be used in different Forex trading strategies. Here is an example of an ADX trading strategy that we can use for trading the Forex markets. The strategy is also complemented from the MACD indicator that uses different settings from the default one. You should also download MT4SE to obtain the Admiral Pivot indicator.
Time frame: Daily
Pairs: EUR/USD, GBP/USD, AUD/USD, USD/CHF, GBP/JPY, EUR/JPY, NZD/USD, USD/CAD
Indicators: MACD(3,10,18), ADX (18 with blue +DI and red -DI), Admiral Pivot (Monthly - MN1)
Source: Admiral Pivot indicator set on Monthly
Source: GBP/USD Daily Chart, Admiral Markets MT4 Platform, Jun 22-Aug 1
Targets are measured by trailing stops or next Admiral Pivot points. Stop-loss is a maximum of 2% risk per trade, or whatever the risk you might see appropriate. Stop should be placed below Admiral Pivot support for long trades and above Admiral Pivot resistance for short trades.
As with so many look-back trend measures, the ADX is a lagging indicator. This means it will not indicate a trend until after one has happened.
Check out one of our educational sections for other Forex and CFD trading insights.