In forex trading, there’s ample logic behind the rhyme “the trend is your friend.” Trading in the direction of a strong trend both minimizes your risk and increases your potential profit.
The average directional index (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 40 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, which uses a standard 14-period setting, is plotted on a separate graph adjacent to that of price action. ADX values, which can range from 0-100, are represented by a single line. Often, traders choose to plot the +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 profit potential.
Plotting all three indicators together allows traders to simultaneously gauge trend direction and strength. When the +DI is above the -DI, it indicates that the price is in an uptrend. In contrast, when the -DI is above the +DI, the 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 the 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, the ADX provides traders with more precise 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 will have 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, the price will consolidate as the 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.
Potential Risks of Using the ADX
Although traders generally rave about the ADX as a trend indicator, it does pose limitations that traders should be aware of. Using the ADX along with the +DI and -DI can help you identify bearish and bullish trends, addressing one of the biggest weaknesses of using the ADX on its own.
The ADX also lacks clear guidance in terms of signals to use when exiting a position. As illustrated above, traders have developed their own methods of timing trade actions based on certain levels on the ADX range, but the indicator itself leaves the guesswork to the trader.
Finally, the ADX offers the inescapable limitation of being a lagging indicator, which means traders are always operating off past data to understand potential price movement. Consequently, there’s always a risk that the indications offered by the ADX will mislead traders into making trades that result in a net loss. For this reason, some traders may choose to pair the ADX with leading indicators that may be useful in corroborating its suggestions.
Using the ADX to Understand Momentum
When using the ADX as a momentum indicator, trace a trend line along the ADX peaks and another one along your price peaks. Successively higher ADX peaks indicate increasing momentum, whereas successively lower peaks suggest decreasing momentum. When the resulting two trend lines form opposite trajectories, it indicates a divergence between the 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 the trend strength diminishes and the price rebounds after this juncture. If the trader were to consider price momentum in addition to trend strength, they 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 trend lines move into agreement.
Pairing the ADX with Other Tools
Pairing the ADX with other momentum tools such as the stochastic oscillator and relative strength index (RSI) can help traders confirm divergences and verify entry and exit signals against overbought and oversold readings for greater precision. Trend strength, direction, and momentum can also be verified using the moving average convergence divergence (MACD).
The stochastic oscillator and MACD are already a popular pairing because of their complementary roles in analyzing trade opportunities. The ADX only adds to this value, and the MACD provides additional context to moving averages that can address some of the inherent shortcomings of the ADX, in particular, and lagging indicators in general.
The RSI, on the other hand, is an excellent pairing with the ADX when you’re looking to improve your timing of trades based on ADX insights. Whereas the ADX reflects the intensity of trends taking place, the RSI can help you identify the right time to open a position, which helps you maximize your profit potential and brings much-needed precision to your trading strategy.
No matter what momentum and trend indicators you choose to leverage in your trading strategy, make sure to confirm your insights across your tool kit to minimize risk and maximize profits.
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.