Measuring Trends With ADX Indicator

  • The Average Directional Movement Index indicator, also known as ADX, is an indicator included in the trend indicator category developed by Welles Wilder and used to measure the strength of a trend. This indicator consists of one line and refers to the Directional Movement Index which consists of two indicators namely the + DI and -DI indicators.

    What are the specifics of this technical indicator ADX? The specifics of the ADX indicator are, this indicator does not indicate the direction of the trend but its strength. The main objective of this indicator other than measuring trend strength is to predict the next phase of the trend and how strong the price momentum is.

    ADX indicator has only one parameter that can be set by the trader, which is the time period used.

    And the standard time period suggested by Welles Wilder is 14 days.

    Like the moving average indicator, the greater the time period used, the more general or smooth movement of the price, but on the other hand, it also results in more rarely presenting detailed price movements.


    What is the ADX Indicator?

    ADX (Average Directional Movement Index) is one indicator of the strength of the trend at the price of a financial instrument that is "lagging" (giving a signal after a trend is formed at a price).

    Initially, ADX was developed by J Welles Wilder as a commodity price indicator, but later it was known to be used also for forex and stock analysis. Also called the Directional Movement Index (DMI)

    This indicator is a combination of three lines, namely the Average Directional Index (ADX) itself, + DI and -DI.

    The Average Directional Index (ADX) shows the strength of the trend regardless of the direction of movement of the trend.

    Meanwhile, + DI and -DI complete ADX by displaying the direction of current price movements. The calculation of ADX, + DI, and -DI manually is very complicated because it involves the formulation of mathematical logic (if-else) and calculation of Average True Range.

    In addition, the formula can be varied by using various Moving Average (MA), such as Smoothed Moving Average, Exponential Moving Average, and Weighted Moving Average.

    However, currently the Average Directional Movement Index can be found easily in a list of trading software indicators commonly used by traders, including Metatrader4 (MT4), so there is no need to count manually.

    In MT4, traders simply search on the "Insert - Indicators - Trend" menu, then choose the time period you want to enter in the calculation. ADX will later appear as a subwindow below the price chart of the observed currency pair, similar to the Oscillator type indicator display.


    ADX Display and Parameter Indicators

    The ADX indicator consists of three components, namely:

    1. ADX itself, which shows the strength of the trend. In general, if ADX is greater than 20, then the trend is considered to begin to strengthen. ADX is between the levels of 20-40 indicating the trend is strong, ADX between levels 40-60 is an overbought/oversold level, while ADX greater than 60 indicates the trend has reached the saturation level and is likely to reverse. ADX line that moves upwards, meaning that the trend is strengthening, both uptrend and downtrend. Conversely, if the ADX line moves downward, then the trend is weakening, both uptrend and downtrend. Common period parameter settings are 14.

    2. + DI or Directional Index for uptrends, usually green. Line + DI will move up if it is an uptrend and move down if it is a downtrend.

    3. -DI or Directional Index for downtrends, usually red. The -DI line will move up if it is downtrend, and move down if it is an uptrend.

    Note that if the + DI and - DI lines intersect (cross), a trend change will occur. Exactly:

    • If + DI cuts -DI from bottom to top, it indicates an uptrend will occur.

    • If –DI cuts + DI from bottom to top, then it indicates a downtrend will occur.


    How To Trade Using ADX indicator?

    Trading rules with ADX indicators are very simple. Beginner and experienced traders can use it.  Entry only if:

    • There is cross + DI and - DI.

    • ADX level is greater than 20 and is moving upwards.

    • if there is a cross + DI and - DI, but the ADX line moves down, meaning the trend is weakening, and it is recommended not to enter.

    • Exit if the trend starts to weaken or the ADX line starts moving downward.

    ADX indicator1.gif

    Pay attention to points A and B in the example image above.

    At point A, –DI cuts + DI from bottom to top, meaning there will be a downtrend. Sell entry after the ADX line moves upwards and is above level 20 (yellow area).

    At point B, + DI cuts - DI from bottom to top, meaning an uptrend will occur. Entry buys after the ADX line moves upwards and is above level 20 (yellow area).

    Exit after the ADX line starts moving downward (the end of the area is yellow).

    On the other hand, + DI and -DI display the direction of price movements. When + DI is above -DI, it means the momentum of current price movements is rising. Whereas if -DI is above + DI, then the momentum of current price movements is down. The Buy signal appears when + DI crosses -DI towards the top, while the Sell signal appears opposite, that is when -DI crosses + DI towards the top. Both of these crossovers often appear in forex analysis using ADX.

    ADX will move between the values of 0 to 100. According to J Welles Wilder, a strong trend is present when ADX is above 25, and there is no trend when ADX is below 20. Therefore, the use of ADX now generally applies rules: If ADX is below 20 means indicating trend weakness, while above 40 indicates the strength of the trend. A very strong trend is indicated by the ADX position above 50.

    One thing to note here is: the use of ADX without + DI and -DI only shows the strength of the trend without indicating the direction of price movements. As can be seen in the example picture above, on October 14, 2016, was marked. When ADX rises beyond 60 towards 64, the price moves down. Here, ADX indicates how strong the Downtrend current is. It can also be seen that at the same moment, -DI is above + DI, where this indicates a Downtrend too.

    On the other hand, + DI and -DI display the direction of price movements. When + DI is above -DI, it means the momentum of current price movements is rising. Whereas if -DI is above + DI, then the momentum of current price movements is down. The Buy signal appears when + DI crosses -DI towards the top, while the Sell signal appears opposite, that is when -DI crosses + DI towards the top. Both of these crossovers often appear in forex analysis using ADX.

    ADX will move between the values of 0 to 100. According to J Welles Wilder, a strong trend is present when ADX is above 25, and there is no trend when ADX is below 20. Therefore, the use of ADX now generally applies rules: If ADX is below 20 means indicating trend weakness, while above 40 indicates the strength of the trend. A very strong trend is indicated by the ADX position above 50.

    One thing to note here is: the use of ADX without + DI and -DI only shows the strength of the trend without indicating the direction of price movements. When ADX rises beyond 60 towards 64, the price moves down. Here, ADX indicates how strong the Downtrend current is. It can also be seen that at the same moment, -DI is above + DI, where this indicates a Downtrend too.


    Another example of trading using ADX

    adx2.png

    In the example of the EURCHF chart above, ADX has been under the 20 scale for a long time, starting from the end of September to December. And we can also see in the graph that the EURCHF price with the price range as above is long enough.

    Starting at the beginning of January ADX begins to climb towards a scale of 50 which indicates the start of a new, strong pattern to be ready for us to follow.

    As predicted, using the ADX EURCHF has a breakdown forming a strong downtrend pattern with around 400 pips

    Now we see another example as shown in the graph below:

    adx3.png

    As the first example above, the EURCHF is stuck below the scale of 20 for quite a long time and a few moments later the EURCHF starts heading to a scale of 50 which shows the strength of the trend to form an uptrend (breakout) pattern.


    Conclusion

    There is only one way to trade using this indicator which is to wait for a breakout or breakdown before determining whether to open a long (buy) or short (sell) position. We can use ADX as a confirmation signal whether the trend will continue the pattern or not. And it can also be used to determine when we close a trading position early.

    For example, when ADX starts to fall below the scale of 50, we can get ready to close the position because it is likely that a sideways pattern will be formed. You can also combine these indicators with other indicators that function to determine the direction of price movements such as MACD, Stochastic or RSI.