Average Directional Index (ADX) is an indicator developed by J. Welles Wilder. It measures the strength of a trend, regardless of direction. ADX can be used to decide between trend-following and range-bound strategies. It can also be combined with two other indicators created by Wilder: Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI). If this is done, the three of them together can be used to catch breakouts.
ADX calculations explained
When ADX is added to a chart, the charting software derives it from +DI and -DI. And these indicators are themselves derived from two other lines that are not shown: +DM and -DM.
+DM is calculated using the high and low prices for each period. If the high of the current period is greater than the high of the previous period, it is considered an “upmove.” If the low of the current period is greater than the low of the previous period, it is considered a “downmove.” If the upmove is greater than the downmove, then +DM is equal to the upmove. If the upmove is less than the downmove, then +DM is equal to zero. +DM is also equal to zero if the upmove is zero.
-DM is calculated in the same way. If the downmove is greater than the upmove, -DM is equal to the downmove (as long as the downmove is not zero). Otherwise, -DM is zero.
Once +DM and -DM are known, the smoothed moving averages of these values are multiplied by 100 and then divided by the Average True Range to get +DI and -DI. The following steps are then taken to derive ADX:
- Add -DI to +DI
- Subtract -DI from +DI
- Divide the answer from step 2 by the answer from step 1
- Find the absolute value of the answer from step 3
- Find the smoothed moving average of the answer from step 4
- Multiply the answer from step 5 by 100
The result of these calculations is an indicator that measures only the strength of a trend, not the direction of the trend. When ADX is above 25, a strong trend is present. When ADX is below 20, the currency pair is ranging. Between 20 and 25 is a grey area that represents either a slow trend or fast movement within a range.
In the chart above, the price for EUR/USD was in a slow, weak downtrend from 6 p.m. Nov. 26 to 6 p.m. Nov. 28. During that time, ADX (light sea green line) spent most of its time between 20 and 25, although it dipped below 20 briefly on two occasions.
The price then broke out into a strong uptrend. During this strong trend, ADX rose above 25 and continued higher. The price began consolidating at 10 a.m. on the 29th, and ADX began to fall. Then, a downtrend started around 12:00 noon on the 30th, causing ADX to rise again.
How to trade ADX
There are two ways to use ADX in Forex trading. First, it can be used as a tool to decide between range-bound and trending strategies. Second, it can be combined with +DI and -DI to find breakouts.
How to use ADX as a tool to determine other strategies
If ADX is above 25, use trend-following strategies such as “contrarian bollinger bands” and RSI failure swings. If ADX is below 20, use range-bound strategies such as horizontal support and resistance lines or regular (non-contrarian) bollinger bands.
How to use ADX combined with +DI and -DI
If a trader inserts an ADX indicator on a chart, most charting software will also display +DI and -DI. These extra indicators can be used in conjunction with ADX to find possible breakouts. Wait until ADX is above 25 (or above 20 in less conservative versions). When +DI crosses -DI from below, buy. When +DI crosses -DI from above, sell.
The following chart shows a sell signal in this strategy. +DI is a yellow-green dotted line and -DI is a wheat-colored dotted line, while ADX is colored light sea green.
ADX is an indicator that measures whether a currency pair is trending or ranging. It can be used to determine what whether ranging or trending strategies should be used. It can also be combined with +DI and -DI to catch breakouts in a trending market. For this reason, traders may want to consider using ADX as one of their indicators.