ADX Indicator Trading Strategies

ADX Indicator Trading Strategies

ADX Indicator & Trading Strategies

Created by legendary trader Welles Wilder in 1978, the Average Directional Movement Index (ADX) is a technical analysis tool used by traders to establish trend strength as well as trend direction. It is common investing wisdom that detecting and trading in the direction of a strong trend is a profitable strategy with minimal risk exposure. This is why ADX is one of the most popular indicators among traders of all levels.

Functionally, the ADX is an excellent indicator for identifying the prevailing conditions in the market. Traders can easily determine whether a market is ranging or trending, and then  apply the appropriate strategy.

ADX belongs to the broader group of trend-following indicators. Other technical analysis tools similar to ADX include the Parabolic SAR, Envelopes and Moving Averages.

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ADX Calculation

The ADX indicator has 3 lines: +DI (green line), -DI (red line) and ADX (black line). These lines are calculated using the formulas below:

+DI = ((Smoothed MA + DM)/ATR) * 100

-DI = ((Smoothed MA – DM)/ATR) * 100

DX = ((+DI – -DI)/(+DI + -DI)) * 100

First ADX = sum n periods of DX / n

After that ADX = ((Prior ADX * n-1) + Current DX) /n

Where:

+DM = Current High – Previous High

-DM = Previous Low – Current Low

ATR = Average True Range

N = Number of periods used in the calculation (the default is usually 14 but traders can adjust this according to their needs)

The above calculation will plot the three lines of the ADX indicator. The +DI (green line) will be the positive directional indicator, whereas the –DI (red line) will be the negative directional indicator. The ADX (black line) is a non-directional indicator (essentially the average difference between +DI and –DI) and is plotted from 0 to 100, with no negative values.

Reading the ADX Indicator

As mentioned above, the ADX line is primarily a momentum indicator. Based on this, a rising ADX implies a strengthening trend, whereas a falling ADX implies a weakening trend. Welles provided the ADX trend strength scale as below:

ADX Value Trend Strength
0-25 Non-trending market or range-bound market
25-50 Strong trend
50-75 Very strong trend
75-100 Extremely strong trend (rarely happens and can be considered unsustainable)

Trend direction is determined by watching the +DI and -DI lines. An uptrend is in place when the +DI is above the -DI; whereas a downtrend is in place when -DI is above the +DI. When +DI and -DI crosses, it indicates that a trend reversal is occurring.

The trend is turning bullish if +DI is crossing above -DI; similarly, the trend is turning bearish if -DI is crossing above +DI. It will be a case of a particularly strong trend if a cross occurs when the ADX line is also going up.

Trading ADX Signals

Here is how to trade the signals generated by ADX:

  • Crossover Setup
    ADX crossovers provide the best entry and exit points for maximising returns in a trending market. For instance, an optimal buy entry signal will be triggered when the ADX is above 25 and the +DI line crosses above the -DI line. The buy order should be held until the -DI crosses above +DI or the ADX drops to below 20. The opposite applies when considering a sell order.
  • Breakouts
    Breakouts are fairly easy to spot on a chart; the hardest task is to differentiate a real breakout from a fake one. ADX helps traders to determine whether a breakout offers a valid trading opportunity. When the price breaks out of a period of consolidation, with an ADX reading of above 25, it implies that there is sufficient momentum for the new trend to be sustained. A reading below 25 would imply an unsustainable or even false breakout.

Combining ADX with Other Indicators

ADX has some weaknesses that make it unsuitable to be used as a standalone indicator. To start with, it is based on moving averages, which means that it is largely a lagging indicator that reacts slower to price changes in the market. ADX is also practically inefficient when trading less volatile or ranging markets. Furthermore, ADX crossovers can happen frequently and deliver choppy signals to traders.

Here are some of the best indicator combinations with ADX that will deliver higher probability trading signals:

  1. ADX and RSI
    ADX indicator values of below 25 show that the underlying market is not trending. This is basically a market that requires range-bound plays. As an oscillator, RSI delivers overbought and oversold trading signals. An RSI reading of above 70 implies overbought conditions, whereas a reading of below 30 implies oversold conditions. A buy order in a ranging market will be when the price is drifting lower, with an ADX reading of below 25 and when the RSI is showing oversold conditions. Similarly, a sell order can be placed when the price is edging higher, with an ADX reading of below 25 and when the RSI is showing overbought conditions.
  2. ADX and Parabolic SAR
    Parabolic SAR is a leading trend following indicator, and when combined with ADX, it could help traders to capture maximum returns in a trending market. ADX crossovers can take time to form in the market, and traders can enter a trending market early with Parabolic SAR when 3 consecutive parabolas are printed in the direction of the trend. Similarly, an early exit signal can be identified by Parabolic SAR when the parabolas flip onto the opposite side of the trend. This can be used instead of waiting for the +DI and -DI crossovers.

Trading with the ADX Indicator at AvaTrade

AvaTrade is an award-winning, globally multi-regulated Forex trading and CFD brokerage. Trade ADX strategies at AvaTrade and enjoy the following advantages:

  • Demo Account. A free demo account to give traders the opportunity to try out different ADX strategies without putting any money on the line.
  • Choice of Assets. Apply ADX strategies on over 1,000 financial assets that include Forex, Stocks trading, Commodities, Indices and Cryptocurrencies.
  • Unparalleled Trading Environment. From advanced, robust and feature-packed trading platforms to efficient payment systems and excellent customer care, AvaTrade ensures that you can focus on your trading activities within a secure trading environment.

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** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.