ADX Indicator Explained - Advanced Forex Strategies

ADX Indicator Explained

By the end of this article, we will have the ADX Indicator explained. With most trading systems generally inclined to use a trend following strategy, the Average Directional Movement Index is a great indicator that can help traders to identify the strength of the trend and thus allow good entry points into a trade. In this article, we take a look at the ADX indicator, what it does and how the ADX can help traders to fine tune their entries in a trend following system.

The Average Directional Movement Index or simply Average Directional Index (ADX) is a trend identifying oscillator. It is a non-directional indicator which merely quantifies the strength of the trend. The ADX is a form of a trading system that was designed by J. Welles Wilder. The ADX Indicator is made up of three indicators.

  • ADX or the Average Directional index
  • Minus Directional Indicator or -DI
  • Plus Directional Indicator or + DI

Together, the three indicators make up the Average Directional Movement Index or ADX for short.

The ADX indicator measures the strength of the trend and is complimented by the rising and falling +DI and -DI lines with the main ADX line pointing to the strength of the trend. The +DI and -DI are the most important elements in the ADX system which forms the basis of the entire indicator. The +DI and -DI are plotted by comparing the difference between consecutive highs and lows.

The chart below shows a 14 period ADX indicator applied to the charts.

ADX Indicator ExplainedAverage Directional Index

How does the ADX Indicator help with trends?

The ADX Indicator’s ADX line is the main indicator which points to how strong or weak a trend is. Plotting the levels of 25 – 30, it is widely accepted that when the ADX moves or stays above this level, it indicates that the prevailing strength is strong. Of course, traders need to be able to enter the trade when the ADX moves above the 25 or 30 level in order to be able to ride the trend.

When the +DI is above the -DI and the ADX is above 25 or 30, it is considered to be a strong uptrend. Likewise, when the -DI is above the +DI and the ADX indicator is above 25 or 30, it points to a strong downtrend. The chart below illustrates how prices behave in relation to the ADX indicator.

ADX Indicator Showing Trend StrengthsADX Indicator Showing Trend Strengths

Now that we understand what the ADX does, the next step is to understand how the ADX can be a great way to help traders with a trend following system. Let’s assume a very basic trend following system such as moving average cross over system. The chart below shows a 50/20 simple moving average cross over system along with the ADX indicator. Conventional trading wisdom would have us to buy or sell when the moving averages crossover. However, experienced traders would know that not all moving average crossovers are reliable. So how can one avoid the choppy markets when the moving averages crossover? Using the ADX Indicator we can simply trade only when the trends are confirmed.

In the chart below, from the left, we first notice the moving average crossing over giving a bullish buy signal followed by a sell signal. Without using the ADX Indicator the average trader would end up buying and selling on the crossovers. But the ADX Indicator actually shows that prices are ranging. Thus, the trader would stay on the sidelines until the markets confirm a trend. This is done a few candles later, when the 20 MA crosses below the 50 MA and the bearish signal is confirmed with the ADX indicator breaking out above the 25 – 30 level, with the –DI staying above the +DI indicator. Because the ADX points to a strong downtrend, even the stops on this short trade would be relatively light while opening up the room for making strong profits in the markets.

Trend following system with ADX IndicatorTrend Following System with ADX Indicator

As shown above, the ADX is a simple yet powerful indicator. In fact a robust trading system can be built by simply using the moving average crossover system and using the ADX to trade only the strong trending markets.

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