In forex trading, there’s ample reason behind the rhyme “the trend is your friend.” Trading in the direction of a strong trend both minimizes risk and increases your potential for profit.
The average directional index, or ADX, was designed to help traders identify trending markets and determine trend strength to remain on the optimal side of a trade. Developed in 1978 by prolific engineer-turned-analyst J. Welles Wilder Jr., this trend indicator has earned its place as a staple in analytical trading strategies for forty years.
The ADX is a hybrid of Wilder’s positive directional indicator (+DI) and negative directional indicator (-DI), with the addition of a simple moving average. Although the +DI and -DI are both indicative of trend direction, the ADX reveals trend strength alone. Because the ADX is a lagging indicator, it’s not ideal for forecasting market changes but rather for confirming existing price trends after they’ve already begun to take shape.
The ADX uses a standard 14-period setting and is plotted on a separate graph adjacent to that of price action. ADX values can range from 0 to 100 and are represented by a single line. Often, traders choose to plot +DI and -DI in the same window as the ADX, which manifests as two additional lines, as shown below.
Recognizing ADX Trends and Gauging Their Strength
When the ADX value falls below 25, it suggests that the trend is weak and warns traders against using trend-following trading strategies. Conversely, ADX readings above 25 typically indicate that the trend is strong enough to warrant trading in the direction of the current trend. ADX values above 40 are considered strong, and any readings that surpass 50 are considered extremely strong. When the trend is strong, trading with the trend has the greatest potential for return.
Plotting all three indicators together allows traders to simultaneously gauge trend direction and strength. When the +DI is above the -DI, it indicates that price is in an uptrend. In contrast, when the -DI is above the +DI, price is in a downtrend. The trader can determine the strength of the uptrend or downtrend by examining the ADX value at the same point in time.
Naturally, whatever insight you derive from the ADX, +DI, and -DI should also be reflected on your price action chart. In the circled section above, the ADX is around 50 (the median of the y-axis), indicating a strong trend, and the -DI is above the +DI, revealing that the trend is moving in a downward direction. If you trace a straight line from the circled point onto the above price action graph, you’ll see that price is, indeed, moving in a strong downtrend.
Benefits of Using the ADX
So what, then, are the benefits of using the ADX, +DI, and -DI to determine trend strength and direction? For starters, using the ADX provides traders with more precise trade entry and exit points. When the ADX moves above 25 and continues to rise, many traders view it as an invitation to enter a trade. Any ADX readings below 25 indicate that the trend is ending and thus serve as a final exit point. That said, entering and exiting the trade close to the 25 line has less profit potential because the trend is either just beginning to form or steadily weakening. For this reason, some traders use a higher value, such as 40, as their trade entry and exit point because ADX movements above 40 indicate a strong trend and the greatest profit potential. Though a trend may continue in the same direction as the ADX falls between 40 and 25, price will consolidate as trend strength diminishes, thereby reducing the trader’s potential profit margin. For this reason, examining ADX peaks and dips can also give traders a sense of market momentum.
Using the ADX to Understand Momentum
When using the ADX as a momentum indicator, trace a trendline along ADX peaks and another one along your price peaks. Successively higher ADX peaks indicates increasing momentum, while successively lower peaks suggests decreasing momentum. When the resulting two trend lines form opposite trajectories, it indicates a divergences between ADX momentum and price. A divergence signifies that momentum is changing and can help traders assess and manage risk.
Not all divergences forecast a trend reversal (divergences can also lead to trend continuations, corrections and consolidations), but they are unequivocally associated with greater market volatility and uncertainty. If a divergence occurs, a trader may choose to place stops closer together, or take a partial profit and exit the trade to minimize risk.
In the circled section of the chart below, the ADX, +DI, and -DI reveal a strong downtrend, but trend strength diminishes and price rebounds after this juncture. If the trader were to consider price momentum in addition to trend strength, he or she would recognize that a slight divergence was present and decide to place a closer stop to minimize risk or wait to enter the trade until both trendlines move into agreement.
Pairing the ADX with other tools
Pairing the ADX with other momentum oscillators like the Stochastic Oscillator and RSI can help traders confirm divergences and verify trade entry and exit signals against overbought and oversold readings for greater precision. Trend strength, direction, and momentum can also be verified using the MACD. No matter what momentum and trend indicators you choose to leverage in your trading strategy, make sure to confirm insights across your toolkit to minimize risk and maximize profit.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.