Welles Wilder was a successful designer of many trading indicators that passed the practice test. With his extensive market experience, Wilder knew that the crucial factor for retail was to create the right framework. But how do you grasp the structure? The ADX indicator is Wilder’s answer. Wilder developed the Average Directional Index (ADX) as an indicator for the interpretation of the market environment. Essentially, it informs you about the direction of the market. The ADX is a trend strength indicator because it shows how strongly a trend is developing and the possible direction in which the market is moving. It develops its full competence in interaction with other indicators and analysis. Recognizing market trends can give traders an advantage and help them to stay on the right side of the market. As the old saying goes, “the trend is your friend”.
What is the ADX indicator?
Recognizing the market trends is the primary strength of the ADX, which has a lasting impact on the choice of other analysis tools. The control value is between 0 and 50. The higher the displayed value, the stronger the trend. The lower the ADX value, the weaker the trend.
The ADX indicator shows three lines that depict price development differently:
- + DI line
- – DI line
- ADX line
The ADX is calculated based on the Directional Movement Index (DMI).
DX = DI-Plus – DI minus divided by DI-Plus – DI minus.
The ADX represents the moving average of the DX. The period is often set to 14 or 18 days.
The rising ADX means that the market is trending.
ADX slope indicates an emerging trend. Traditional ADX analysis confirms the pattern here.
The observation of the ADX slope gives an early signal for a trending market. The ADX rise is positive in two places on the chart, indicating a trending market.
If we would wait for the ADX to rise above 25 to confirm the trend, the signal would not have come through the ADX rise until after several periods.
Of course, the ADX slope is not the philosopher’s stone. The ADX slope changes direction frequently and is more prone to giving the wrong signals. However, if you pay attention to the price action in connection with the ADX slope, you can reduce false signals generated.
And this is how it works: If the price moves in one direction, the ADX slope should remain positive.
Compare this signal to the first sign of the uptrend we pointed out. The prices rose before the change in the ADX slope began. Prices continued to rise as the ADX line turned up for the next candles. This is a more reliable sign that there is a trend. A falling ADX indicates a consolidating market.
ADX slope shows a possible, sideways market. False breakouts are typical in a consolidating market. The traditional ADX analysis confirms the trendless market here.
Once the confirmation of consolidation has been made, you may be more skeptical of positive signals of the ADX slope, as failed breakouts can be more frequent. As long as a strong breakout from consolidation does not accompany the positive ADX rise, you may expect the breakout to fail.
How to trade with the ADX indicator?
Although the ADX is a useful tool in its own right, it was part of the Wilder DM system.
The directional movement system consists of three lines:
- The ADX captures the strength of the trend.
- The DI+ records bullish price movements (upward direction).
- The DI- tracks bearish price movements (downward trend).
The + D1 and – D1 indicators show the difference between the uptrend and the downtrend separately, which results in creating useful trading signals. The red line running horizontally through the middle represents the 25 levels. If the blue ADX line falls below this level, the trader recognizes that there is a ranging market or that placing further trades is not worthwhile because a weak trend determines the demand.
If the value is over 25, a strong trend emerges. If the ADX indicator moves between 30 and 50, it means there’s strong trend. If the line moves to 50 and above, the trend is at its peak. Experienced traders no longer place any further trade, as the market may reverse after reaching this high. An ADX indicator has a sideways movement below 30. Below 15, a strong move is quite likely.
The lines + DI and – DI signal the trend direction. The main ADX line represents the smoothed average of price movements. If the value rises above 25, this is a signal for a trend beginning. The + DI and the – DI lines signal through interaction, whether there is an upward or downward trend. If the + DI line goes beyond the – DI line, there is an upward trend. If the + DI line falls below the – DI line, this means the reverse price trend in the form of a downward trend. If the + DI line crosses the higher – DI line, this change signals a possible upward bias. The ADX value is calculated based on trading periods, also called candlesticks. The default setting is 14 periods.
ADX trading strategy
The following trading strategies give you a comprehensive insight into how the ADX works. They will also show you how it works with other popular trading indicators.
You should already be familiar with the ADX to understand the following strategies.
The ADX with the Directional Movement Index (DMI)
The following interpretation is only valid if the ADX is above a threshold (usually with a setting of 20 or 25):
- Bullish: DI + > DI-
- Bearish: DI- > DI +
The ADX in the DI system:
- ADX (blue) is above 25.
- DI- (red) moves via DI + (green); Beginning of a bear trend.
- DI + crosses over DI-; bullish trend wins.
- ADX fell below 25, indicating that the market was no longer trending.
This system is a simple setup. I would be sure to add much more detailed analysis including technical indicators, price action, volume, sentiment, fundementals, etc.
The 2-period ADX strategy
This strategy is quite simple. You need to look for two factors:
- 20 EMA
- ADX slope
If the price breaks below the 20-EMA and the ADX is sloping upwards, then you may look to sell an asset. Take a look at the chart below:
ADX indicator conclusion
The ADX indicator is a powerful trading tool that not only helps in filtering trade signals but it also helps in determining the overall direction and strength of a trend. You can combine the ADX with any other indicator to add further confirmation to your trade entries.
One of the best combinations is with the Relative Strength Index, or RSI. Because the ADX measures the intensity of the trend the RSI can help with entries and exits by giving a time based component to the trend.
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If you are a fan of the ADX indicator, then you might want to take a look at the free ADX EA that I have developed. It can automatically analyse charts for buy and sell signals based on various ADX trading strategies.
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