Average Directional Index (ADX)

MoneyBestPal Team
A technical analysis indicator that measures the strength of a trend in the market.
Image: Moneybestpal.com

A technical analysis indicator called the Average Directional Index (ADX) gauges how strongly a trend is prevailing in the market. It is based on the price's direction, which is determined by contrasting the highs and lows of succeeding periods. 

The Plus Directional Indicator (+DI), the Minus Directional Indicator (-DI), and the ADX line are the three lines that make up the ADX.

The difference between +DI and -DI is averaged out to get the ADX line. A greater trend is indicated by higher numbers, which range from 0 to 100. The ADX merely shows the size of the trend; it does not show the trend's direction. According to a widely accepted interpretation, an ADX reading above 25 denotes a moving market, and an ADX reading below 20 denotes a range-bound or non-trending market.

The smoothed averages of the positive and negative directional movement are used to create the +DI and -DI lines, respectively. When the current high minus the prior high is greater than the previous low minus the current low, the directional movement is positive; when the converse is true, it is negative. The +DI and -DI lines depict the trend's direction; +DI above -DI denotes an uptrend and -DI above +DI denotes a downward trend.

The ADX can be used as a trading system by combining it with other indicators or price patterns. Some traders, for instance, utilize the ADX to weed out choppy or weak trends and concentrate on strong ones. They might look for an ADX over a certain level, like 30 or 40, and then utilize additional indicators, like trendlines or moving averages, to pinpoint entry and exit points inside the trend.

A different way to use the ADX is to search for divergence between the ADX and the price. This happens when the ADX shifts against the price, pointing to a possible trend reversal or weakening. For instance, if a price trend is up while the ADX is falling, this could indicate that the trend is losing steam and may soon turn down. 

On the other hand, if a downtrend is underway and the price is making lower highs and lower lows while the ADX is rising, this suggests that the downtrend is gaining momentum and may persist.

In a range-bound market, the ADX can also be utilized to locate breakout spots. A breakout happens when the price exits a trading range or consolidation zone, indicating the start of a new trend or the continuation of an existing one. 

By indicating an increase in trend strength, the ADX can support a breakout. A typical strategy is to watch for an ADX that crosses above a predetermined level, such 20 or 25, after having been below it for some time. This suggests the emergence of a fresh trend or the revival of an earlier one.

The following chart shows an example of how to use the ADX in different market scenarios.
Image: TradingView

On this graph, we can see how the ADX can be used to pinpoint trending, non-trending, and breakout circumstances. The ADX in points A and B is below 20, which indicates that the market is not moving. With no discernible direction, the price is ranging horizontally in a small area. 

The ADX crosses above 25, indicating an upside breakout, in point C. Price exits the range and begins an uptrend. The bullish trend is confirmed when the +DI crosses above the -DI.

The ADX is above 40 in point D, which denotes a strong uptrend. A rising trendline is followed by the price, which also produces higher highs and higher lows. As seen in point E, the price keeps rising as the ADX begins to trend downward. 

As the ADX and price are diverging, it is possible that the uptrend is waning and may shortly reverse. Point F's ADX decreases to below 25, which denotes a weakening of the trend. Additionally, the price reverts to a horizontal trend after breaking below the trendline.

The ADX is a helpful tool for traders who seek to gauge and capitalize on trend strength. By focusing on strong patterns, can assist in filtering out weak or distracting ones. By exhibiting divergence or crossover signs, it can also aid in the detection of future breakouts or reversals. 

To be utilized alone or naively is not recommended, as with any indicator. Indicators, price movement, support and resistance levels, chart patterns, and other technical analysis tools should all be used in conjunction with it.