The Average Directional Index (ADX) also called as non-directional trend strength indicator is a technical analysis tool that tells the trader the strength of the market trend. It does not depict the direction of the trend but it refers only whether the market is trending or not and how strong the trend is. It can also be used to identify whether the trend is going to start or increasing or going to end or decreasing. So, it is an ideal tool to set the timings of when to enter the trade and when to exit the trade before trend reverse, hence reducing the risk and increasing the profit potential. It can equally be applied on all financial instruments like stocks, forex, commodities and crypto.
Average Directional Index
The average directional index is used to identify the strength of a trend. It finds out whether a typical stock or currency pair is in trending stage or in range bound stage. By combining it with other technical indicator that determine the direction of the trend like 200-period moving average, it can be used to enter and exit the trades. The average directional index is also helpful for trader to trader according to their mindset whether they like healthy or long-term trend or they are going for swing trades. They have to set their timeframe accordingly. For example, if a trader is comfortable with swing trading, he may enter a trend which is strong in one hour time frame. The other way to use it to wait for the breakout and then decide whether to go short or long.
Average Directional Values and Trend Strength
The average directional index is a momentum indicator and its values ranges from 0 to 100. The higher the number depicts the stronger the trend is. When the value of ADX is lower, it particularly depicts that the market is going sideways. The above 50 value shows that the market is in the strong trend. Keep in mind that it does not depict whether the market is bullish or bearish as it is a non-directional indicator. So, the higher the value, the stronger is the trend regardless of its direction.
Interpretation of Average Directional Index values
If the value of the average directional index is rising, it means the trend is strengthening and showing a possible entry level.
If the value of average directional index is falling, it means the trend is weakening and showing a possible exit point.
If the ADX value is below 20 it means there is no trend and the market is moving sideways.
If the value of ADX is between 20 to 40. It means the trend is starting and there is a possible entry level for either long or short trades depending upon the direction of the trend.
If the value of ADX is between 40 to 50. It means the trend has already been started and the market is in the strong uptrend. At this level, see the possible entry level i.e. when market gives some discount in price.
If the value of ADX is above 50. It means the trend is very strong or market is in the power trend. Be careful while taking trades at this level as the trend may end soon.
We will not go deeply into its calculation and formula of average directional index (ADX). Just for an idea, it is calculated on the basis of 14-period moving average. It can be used in any time frame whether is 10-minutes, one-hour, four-hour or daily time frame.
Let’s understand average directional index with the help of an example.
In the above picture, the average directional index is showing its value below 20. We can clearly see in the above section of the chart that the market is moving sideways. As the market is in range bound section, so for trend traders, it is not suggested to enter the market at this stage. Although experienced trades can trade such a market by applying the indicators that are good for range bound market.
Let’s take another example of trending market.
In the above chart, the Average directional index is showing that its value is above 20 and is rising. The value going above 20 means that the market is entering into trend phase. It may indicate a possible entry point. As the value of average directional index is rising, it means the trend is getting stronger and stronger. Here do not confuse the direction of the average index value with the direction of the trend. In the above picture, you can clearly see that the direction of the ADX is upward while on the other hand the direction of the trend is downward or bearish. So, here comes the point that average directional index is not depicting the strength of the trend not the direction. You can use other indicator to define the direction of the trend and enter the trade by identifying the strength through ADX. How we can use it with another indicator? For that see the next example.
Average Directional Index and Moving Average
Here, we will use the 200-period moving average to identify the direction of the trend and average directional index to calculate the strength of the trend.
In the above chart, you can clearly see that the price is consistently above 200-period moving average. It means that the price is in the uptrend in the long run. Now the next step is where to enter or exit the market by using the average directional index.
If the value of average directional index is increasing and crossing the 20 points, we can go long as the market direction is upward. So, it is our long entry point. Similarly, as the value of average directional index is decreasing and come below 20, we will exit the trade as the trend is over. And there is an expectation that the market may move side ways for sometimes or the trend may reverse.
One of the disadvantages of average directional index is that it is a lagging indicator and provides late signals. To show its reading the trend has already been started. Before a trader enters into a trade on the basis of average directional index, the trend already covers a lot of distance. In the same way, it also shows exit signals late and the trader have to give back some of their profit to market before they exit the trade. The second disadvantage is that, it is a trending indicator and not useful in rang bound market.