Average Directional Index: How to Use The Trend Strength Indicator?
Average Directional Index (ADX) effectively identifies the strength of an ongoing market trend, which can help you in taking ideal entry or exit positions. Developed by popular commodity trader Welles Wilder, ADX was mainly used for trading commodity futures but it can be just as effective for other assets as well. In this article, we take a deep dive into the ADX indicator and how you can trade with it.
What is the Average Directional Index?
The ADX is a strength indicator that measures how strong or weak a particular market trend is in forex trading. The indicator enables traders to enter long or short trades based on the trend's strength in the market. The ADX is essentially the average of all the price range values in a 14-period time frame. It finds out if there is an uptrend or downtrend through negative and positive directional index lines.
- The negative directional index (-DI) measures how strong a downtrend is
- The positive directional index (+DI) measures how strong an uptrend is
The higher the slope of the negative and positive directional index line, the stronger the trend.
How is the Average Directional Index calculated?
1. To calculate ADX, you need to start by calculating Directional Movement Index (+DM and -DM), along with Average True Range (ATR) for the specific period. Usually a fourteen day period is used + DM = Current High - Previous High -DM = Previous Low - Current Low Take a note of the following:
- Use +DM whenever the (Current High price – Previous High price) is more than (Previous Low price – Current Low price)
- Use -DM whenever the (Previous Low price – Current Low price) is more than the (Current High price – Previous High price)
- The true range of the first 14 observations will be the first 14 true rage price readings
- Next true range values will be the first true range values – (previous 14 period true range value/ 14) + current true range
2. Smoothen out the 14-day period averages for +DM, -DM, and ATR
3. Next, calculate the directional indexes by using the following formula +DI = [(Smoothed + DM)/ATR] * 100 -DI = [(Smoothed - DM)/ATR] * 100
4. To get the ADX, you need to calculate the DX values for at least 14 periods, and then smoothen out the results with all DX . Directional Index (DX) = absolute values of [(+DI - -DI)/(+DI + -DI)] * 100
5. Here’s how you can calculate the ADX for 14 periods ADX = [(Prior ADX * 13) + (Current ADX)]/14
How is the Average Directional Index calculated?
ADX's reading above 25 signals a strong trend, and any reading below 20 signals a weak trend. Whenever the increasing ADX value starts declining, it suggests that the existing trend is coming to an end. If an uptrend is ending, it signals traders to exit the trade, whereas a downtrend ending signals traders to enter new trades. On the other hand, if the ADX's value has been low for some time and starts increasing gradually, it signals traders that the existing trend is strengthening and that they should trade in the direction of the trend. During an uptrend, it sends traders a signal to enter the market, and during downtrends, it signals traders to exit the market.
Top Average Directional Index Strategies
1. Directional Index Crossover Strategy
The Average Directional Index consists of the ADX line and two other directional indexes (+DI and -DI). During a downtrend, at the point where +DI and -DI cross each other, traders receive a sell signal in the market to trade along with the trend. When there is an uptrend, this crossover sends a buy signal to the traders.
2. Uptrend and Downtrend Confirmation Strategy
This is a trend continuation strategy that confirms an ongoing trend in the market.
- Entry orders are placed when an uptrend is confirmed
- Exit orders are placed when a downtrend is confirmed
When the ADX shows a reading of 25 or above in an uptrend, it indicates a strong trend continuation and signals traders to place buy orders in order to trade with the existing market trend. However, during a downturned, when the ADX shows a reading of 25 or above, a falling market is confirmed that sends sell signals to the traders.
3. No Trend Zone Strategy
The No trend zone strategy allows traders to identify the area in the market which isn’t following any strong trend. It's recommended to not trade in these specific zones since they don’t follow any trend or potential path. Instead, traders should wait for a breakout to place buy or sell orders. In a ranging market, where a currency pair trades for a long time in between a particular price range, the ADX helps in identifying when there is an absence of a strong trend. This helps traders avoid placing orders in a situation of a weak trend.
4. +DI and ADX Long Uptrend Strategy
The No trend zone strategy allows traders to identify the area in the market which isn’t following any strong trend. It's recThe +DI and ADX long uptrend strategy is a long strategy that helps traders identify potential price levels where they can place long orders. During an uptrend, when the ADX shows a reading of 25 and above, crossing over with the +DI line sloping upwards, it sends strong buy signals to the traders as an uptrend confirms. On the other hand, if the ADX's reading falls below 25, and it crosses over with the -DI line, it indicates that a trend is weakening and signals traders to place sell orders to exit the market.
Use Pivot Points to identify multiple support and resistance levels
With the help of the ADX indicator, traders can make market exit and entry decisions accordingly. Open a trading account with Blueberry Markets to experience a seamless trading process with advanced tools like the MetaTrader to support you. Sign up for a live trading account or try a risk-free demo account today.
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