Technical analysis is a trading discipline that involves researching and analyzing past market data to make predictions about future performance. Traders in this field are called technical analysts. These individuals look for entry and exit points in the market using historical prices and trading volume. Charts, graphs, and other tools are important to technical analysis. In this article, we look at the average directional index (ADX), the formula, how it's calculated, and how to use it when trading.
Key Takeaways
- The average directional index is a tool used in technical analysis to determine market trends.
- Traders can also use the ADX to determine whether to make a trade and what position to take if they do so.
- Market trends move higher with a positive directional indicator and move lower with a negative directional indicator.
- The positive and negative directional movements are found by calculating the up-move or high minus the previous high, and down-move or current low minus the previous low.
What Is the Average Directional Index (ADX)?
The average directional index is a tool used in technical analysis. It is the primary indicator among the five indicators that make up a technical trading system. This indicator was developed by J. Welles Wilder, Jr.. Wilder was a mechanical engineer turned real estate investor and developer. He later became a full-time market and trading researcher, making major advances in the field of technical analysis.
The ADX helps traders understand the strength of market trends, which can move higher or lower. This is highlighted by two indicators:
- Thepositive directional indicator(+DI)
- Thenegative directional indicator(-DI)
These two indicators are also accompanied by a third line. This line is non-directional and is the difference between the positive and negative indicators. Together, these indicators help assess whether a trade should be taken long or short, or if a trade should be taken at all.
While the ADX is primarily used as an indicator of momentum or trend strength, the total ADX system is also used as a directional indicator.
Formula and Calculation of the Average Directional Index (ADX)
To calculate the ADX, determine the + and - directional movement (DM). The +DM and -DM are found by calculating the up-move or current high minus the previous high, and down-move or current low minus the previous low.
If the up-move is greater than the down-move and greater than zero, the +DM equals the up-move; otherwise, it equals zero. If the down-move is greater than the up-move and greater than zero, the -DM equals the down-move; otherwise, it equals zero.
- The positive directional indicator, or +DI, equals 100 times the exponential moving average (EMA) of +DM divided by the average true range over a given number of periods (Welles usually used 14 periods.)
- The negative directional indicator, or -DI, equals 100 times the exponential moving average of -DM divided by the average true range (ATR).
The ADX indicator itself equals 100 times the exponential moving average of the absolute value of (+DI minus -DI) divided by (+DI plus -DI).
How to Use and Trade the Average Directional Index (ADX)
The ADX is used to indicate several things, notably market direction, the existence or nonexistence of a trend, and market momentum. Market direction is determined by the levels of the +DI and -DI. As such, the market direction is:
- Up if +DI is the higher number
- Down if -DI is the greater number
The ADX indicator, which varies in value from zero to 100, is the primary momentum indicator. A value over 20 indicates the existence of a trend while a value over 40 indicates a strong trend.
As with any other technical tool, the ADX works best when it is used with other indicators. Traders may want to consider using it with the relative strength index (RSI). While the ADX can help highlight the strength of a trend, the RSI can identify entry and exit opportunities.
Why Is the Average Directional Index Important?
The average directional index is a tool used by many technical analysts. Traders can use it to determine trends in the market and, more specifically, whether certain securities are trending. This can help them make important decisions about whether to hold off or advance on a trade—and which position to take if they make the trade.
What Is an Oscillator?
An oscillator is a tool used by technical analysts to make predictions about future changes in the market. These momentum indicators rise and fall between two extreme levels. They help traders determine overbought or oversold conditions in the market. An overbought asset is characterized by the higher extreme while the lower extreme indicates that an asset is oversold. Traders can also use oscillators to understand price movements and market momentum.
What Are the Benefits of Using the ADX?
The ADX is a technical indicator that helps traders identify trends in the market. Traders can also use this indicator to determine whether prices are moving up and down within a specific range. Investors can use this information to make important decisions about whether to buy or sell securities. It is important, though, to realize that the ADX should be used with other indicators to get the best results.
What Are Some of the Limitations of the ADX?
There are several downsides to using the ADX as a technical trading tool on its own. The ADX helps traders measure the strength of a trend but it may also provide them with false signals. This can happen when there are multiple crossovers, which can make it complicated to discern the best entry or exit points as trends make quick changes in direction. The ADX is also a lagging indicator, which means it moves behind prices. As such, it doesn't necessarily provide accurate entry or exit signals. This is why the ADX should be used with other technical trading tools and indicators so traders can make better-informed decisions.
The Bottom Line
Technical traders have a wide range of tools and indicators at their disposal when making important trading decisions. The average directional index helps them determine the strength of market trends as well as their direction. One thing to keep in mind, though, is that the ADX is a lagging indicator. As such, it doesn't keep up with prices. This is why new and experienced traders should consider using it with other indicators. Doing so can help them gain more insight into the market and mitigate their losses.
