How to trade using Average Directional Index (ADX)?

Average Directional Index(ADX) is both a trend and momentum indicator that is used to determine the strength of the market trend. This indicator was developed by Welles Wilder–who also developed the Average True Range and Parabolic SAR and other indicators.

It fluctuates from 0 to 100%. Readings below 20 indicate a weak trend and above 50 indicate a strong trend.

The Average Directional Index (ADX) is  composed of  three lines indicator that includes the ADX line, Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI)

The three indicators in one are used to tell both the trend direction and the trend strength. When the +DI is above the -DI, buying is stronger than selling. When -DI is above the +DI, selling is stronger than buying and when ADX is below 20, signals weak trend and above 50 strong trend.

NB. ADX  alone does not show whether the trend is bullish or bearish therefore it does not give the trend direction, just tells the strength.

It can also be used to identify overbought and oversold area on a market chart and to determine the entry and exit points.

Some platforms provide ADX indicator with additional -DI and +DI indicators that would help traders in determining the direction of trend while using ADX while others may not.

Major important notes:

  • The ADX line(blue line), measures the strength of the trend but does not tell the direction.
  • The +DI(green line), the positive directional movement indicator measures how strongly prices move upwards (strength of buyers).
  • The -DI(red line), the negative directional movement indicator measures the strength of sellers in a downtrend.

So when trading ADX indicator you need the help of the two indicators +D and –D which give the direction of the trend.

When +D line(green) crosses above the –D line(red) and the ADX line(blue) is above 20, it indicates  that a strong uptrend is beginning which gives a buy signal.

When the ADX line is above 50, this means the buyers have been in possession of the market for long. This indicates over bought conditions which may be a sign of a trend coming to an end. This signals a probable change in the direction of the trend giving you a warning to exit the buy trade or to prepare for a sell position .

As ADX falls below 50, it’s an indication of a falling momentum in the uptrend.

Meanwhile, when the –D line crosses over the +D and ADX is above 20, it shows  that a strong downtrend is beginning giving you a sell signal.

When ADX goes above 50 and -D is above +D, it is an indication that the sellers are stronger than buyers and a trend may be nearing an end. This signals a probable change in the direction of the trend giving you a sell.  As it falls below 50, it indicates a fall in the momentum of the down trend.

When the ADX line is ranging between 20 and 25, it is an indicates a ranging market environment, therefore you can prepare to trade in a ranging market taking advantage of small price movements or prepare to exit your trade position. As ADX line falls below 20, this indicates a very weak trend and it may lead to a change in the direction of the price trend.

From the chart above,  you realize that every time the ADX line, goes beyond 50 and fall back below, a trend changes shortly after which is an indication for end of one trend and beginning of a new trend. Bearing that in mind you will be able to determine your entry and exit points. 

Again,you can also realize that ADX cannot be used independently with out the help of +DI and –DI indicators because it does not identify the kind of trend direction price is taking.

ADX below 20 signals a very weak trend and below 25 ranging market conditions.

Like any other indicator, ADX has got its shortcomings like making fake signals so it is not a perfect indicator. To get strong signals it should be used along with other indicators not forgetting to use risk management to minimize your losses just in case a trade goes against you.

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