The ADX indicator or Average Directional Index indication system consists of three indicator lines, drawn on the same chart. The ADX main line (also called The Average Directional Index) measures trend strength. The other two indicators, Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), complement ADX by defining trend direction.
This indicator along with the trading system was developed by Welles Wilder. Wilder has designed ADX for commodities and daily trading. Nevertheless, countless traders use this indicator for stock and forex trading.
Welles Wilder described this indicator along with trading techniques in his book “New concepts in technical trading systems, 1978”.
Sea Green line – ADX main line. Dotted Wheat line – -DI. Dotted Yellow Green line – +DI.
The ADX. is a combination of two indicators developed by W. Wilder, the positive (uptrend) directional indicator (+DI) and negative (downtrend) directional indicator (-DI). The ADX shows both indicators and on one chart and also calculates trend strengths. +DI and −DI calculated based on price data consisting of high, low, and closing prices of each period (typically each day or each hour). The principle of calculating (+DM and −DM):
UpMove = current bar high – previous bar high
DownMove = current bar low − previous bar low
if UpMove > DownMove && UpMove > 0 : +DM = UpMove; else +DM = 0;
if DownMove > UpMove && DownMove > 0: −DM = DownMove; else −DM = 0;
For further calculation we need to choose period N. N = 14 (Number of periods, originally Wilder used 14 days); SMMA and ATR will be calculated using this period.
+DI = 100 * SMMA (+DM)/ATR (average true range indicator of N period);
−DI = 100 * SMMA (−DM)/ATR (average true range indicator of N period);
ADX = 100 * SMMA(+DI − −DI) / (+DI + −DI);
Variations of this calculation typically involve tuning moving average to the market behavior. Wilder used SMMA (Smoothed Moving Average).
How to use it
The basic principles of use are an indication, whether the current market in trending or stagnating mode. Also, this indicator is often used for determining turnaround points of the trend, by comparing extremums with older ones.
The ADX main line does not indicate trend direction, only trend strength. This indicator has relatively significant lag. Thus it will react only on settled trend movements. ADX ranges between 0 and 100. Generally, ADX readings below 20 indicate trend weakness, and readings above 40 indicate trend strength. Readings above 50 indicate a solid strong trend. Alternative interpretations have also been proposed and accepted among technical analysts. For example, it has been shown how ADX Indicator is a reliable coincident indicator of classic chart pattern development, whereby ADX readings below 20 occur just before pattern breakouts. One of the common techniques for ADX is to monitor all available assets and determine what asset currently are in the trending state.
The ADX indicator does not give direct “buy” or “sell” signals. It does, however, give some perspective on whether the price is in the trending or ranging state. Low readings imply that have a trading range or the beginning of a trend. Extremely high readings signals that soon the trend likely will come to an end.
Sea Green line – ADX main line. Dotted Blue line – -DI. Dotted Orange line – +DI.
As we can see, ADX line jumps higher than 25, when the trend is starting to increase power. During quiet periods, ADX stays at low levels. -DI higher, when there is a Downtrend, +DI dominates during Uptrend.
Alexander Elder strategy
Various predictive strategies have been devised using ADX indicator. Alexander Elder writes about one of this method in his book “Trading for a Living”. According to A. Elder, there is a buy signal when the ADX Indicator peaks and starts to decline, when the +DI is higher than -DI. With this strategy, one should sell when the ADX stops falling and goes flat.
To adjust this strategy for Forex trading, we should consider the main difference between Stocks and Forex markets behavior. The behavior of Uptrend and Downtrend for Stocks have rather different nature than the Forex currencies have. Stocks grow or stay flat most of the time, failings of the Stock price are much more active and fast than Forex movements. That is why Elder described only the case for Buying signal. Nevertheless, for the FX market, we could also use mirrored form or this strategy as the Sell signal.