Trading strategy: how to use ADX indicator?

The ADX indicates a strong trend when its value is above 25 and a weak trend when it falls below 20. Traders can generate signals by observing crossovers between the -DI and +DI lines. For instance, if the +DI line crosses above the -DI line while the ADX is above 20—preferably above 25—this may serve as a potential buy signal. With a well-defined trading strategy, investors will be better equipped to navigate the market.

What is the Average Directional Index?

The Average Directional Index (ADX) is a technical analysis tool used to assess the strength of trends. It is a standard feature on most trading platforms.

To measure trend strength, the ADX is calculated using the moving average (MA) of price range expansions over a specified period, typically 14 days, but it can be applied to any timeframe.

Developed by J. Welles Wilder, Jr., the ADX was originally designed for commodities but can also be effectively used for foreign exchange (forex), stocks, futures, indices, and exchange-traded funds (ETFs).

Calculating the ADX

The key purpose of the average directional index indicator is to find out whether an asset is trending in a direction or stuck in a range. It is often used as a complement to other technical indicators.

The ADX is a lagging indicator, meaning that a trend must already be established before the index can generate its signal.

An ADX chart typically includes three lines: the ADX line, the positive directional indicator (+DI), and the negative directional indicator (-DI).

The +DI line reflects the strength of upward movement, calculated by subtracting the previous day’s high from the current day’s high.

Conversely, the -DI line measures the strength of downward movement, derived by subtracting the previous day’s low from the current day’s low.

The ADX line indicates the overall strength of the movement over a specified period.

The positive directional indicator is calculated as 100 times the exponential moving average (EMA) of +DI divided by the average true range (ATR) over a set number of periods (typically 14 days). Similarly, -DI is 100 times the EMA of -DI divided by the ATR.

How to use the ADX indicator

One of the most important things to remember about ADX trading is that the indicator moves regardless of the direction of the underlying asset, showing only the strength of the trend. Both strong upward and downward trends increase the average directional index.

The ADX indicator is measured on a scale from 0 to 100. The higher the ADX reading, the greater the strength of a trend.

ADX below 20: The market is currently not trending

ADX crosses above 20: A new trend is emerging.

ADX between 20 and 40: This is considered as a confirmation of an emerging trend.

ADX above 40: The trend is very strong.

ADX crosses 50: the trend is extremely strong.

ADX crosses 70: A very rare occasion, called a “power trend”.

Advantages and Disadvantages of the ADX Indicator

Advantages
1. The Average Directional Index (ADX) helps traders assess the strength of a trend and the potential for trend reversals.
2. Traders can use the ADX to identify optimal entry and exit points for their trades.
3. The ADX can signal potential overbought or oversold conditions in the market.

Disadvantages
1. The ADX may produce false signals, which can lead to trading losses.
2. As a lagging indicator, the ADX may prompt traders to act too late on potential trades.
3. The ADX offers limited insights into market duration, providing no indication of how long a trend may persist.

Conclusion

The ADX can be a valuable tool for traders by indicating the strength and intensity of trends, potentially aiding in more informed trading decisions. It is often best used in conjunction with other technical analysis tools for a more comprehensive view of market trends.

However, it's essential to recognize that any trading strategy involving the ADX carries risks. Implementing a solid risk management plan is crucial for protecting capital. Traders should conduct thorough research before making decisions, considering their market knowledge, risk tolerance, and portfolio diversification. Additionally, they should avoid trading with funds they cannot afford to lose.

When considering shares, indices, forex (foreign exchange) and commodities for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss.

Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.