The Average Directional Index (ADX) is a technical analysis indicator used to measure the strength and momentum of a trend in financial markets. It was developed by J. Welles Wilder Jr. and was first introduced in his book “New Concepts in Technical Trading Systems” in 1978.
The Average Directional Index (ADX) is calculated in the following steps:
- Calculate the positive directional movement (+DM) and the negative directional movement (-DM) for a given time period (usually 14 periods).
+DM = Current High – Previous High -DM = Previous Low – Current Low
Note: If both +DM and -DM are zero, then no directional movement has occurred, and the values are discarded.
- Calculate the True Range (TR) for the same time period.
TR = Max [(Current High – Current Low), abs (Current High – Previous Close), abs (Current Low – Previous Close)]
- Calculate the Directional Movement Index (DX) using the following formula:
DX = 100 * (|+DM – (-DM) | / TR)
Note: The absolute value is used to ensure that the DX is always positive.
- Calculate the Moving Average of DX over a specified number of periods (usually 14 periods) to obtain the ADX.
ADX = Moving Average of DX
Note: The Moving Average can be a simple moving average, an exponential moving average, or any other type of moving average, depending on the trader’s preference.
The ADX value typically ranges between 0 and 100, with values above 25 indicating a strong trend, and values below 20 suggesting a weak trend or a range-bound market.
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How to use ADX Indicator?
The Average Directional Index indicator is used to identify the strength and momentum of a trend in financial markets. Here are some ways to use the Average Directional Index indicator:
- Trend Identification: The ADX indicator can be used to identify the presence and strength of a trend in the market. When the ADX is above 25, it suggests a strong trend, while values below 20 indicate a weak trend or a range-bound market.
- Confirmation of Trends: The Average Directional Index indicator can be used to confirm the direction of a trend. If the ADX is rising while the price is also rising, it suggests that the uptrend is getting stronger. Similarly, if the ADX is rising while the price is falling, it suggests that the downtrend is getting stronger.
- Trade Entries and Exits: The ADX indicator can be used to identify potential entry and exit points in the market. Traders may enter long positions when the ADX is rising and above 25, indicating a strong uptrend, and may exit long positions when the ADX falls below 25. Conversely, traders may enter short positions when the ADX is rising and above 25, indicating a strong downtrend, and may exit short positions when the ADX falls below 25.
- Filter for Other Indicators: The ADX indicator can also be used as a filter for other technical indicators. For example, traders may only take long positions when the Average Directional Index is rising and above 25 and the Moving Average Convergence Divergence (MACD) indicator is also bullish.
Pros and Cons of ADX Indicator:
The Average Directional Index (ADX) has both advantages and limitations. Here are some pros and cons of using the ADX indicator:
- Measures Trend Strength: The ADX indicator is an effective tool for measuring the strength of a trend. It provides a numerical value between 0 and 100 that represents the strength of the trend, making it easy for traders to interpret and use.
- Easy to Use: The Average Directional Index indicator is easy to use and understand, even for novice traders. It is a simple and straightforward tool that can be used to identify trends and potential trading opportunities.
- Can be Used with Other Indicators: The Average Directional Index indicator can be used in conjunction with other technical indicators to provide more accurate trading signals. For example, it can be used with the Moving Average Convergence Divergence (MACD) indicator to confirm the direction of the trend.
- Versatile: The ADX indicator can be used on any financial instrument, including stocks, futures, currencies, and commodities.
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- Lagging Indicator: The ADX indicator is a lagging indicator, which means that it may not provide timely signals for traders to enter or exit trades. Because of this, you may miss opportunities or face losses.
- False Signals: The Average Directional Index indicator can also generate false signals in choppy or range-bound markets. This can lead to losses for traders who rely solely on the ADX indicator to make trading decisions.
- Limited in Scope: The ADX indicator is limited in scope and does not take into account other market factors, such as news events, economic data, and geopolitical risks, that can impact the direction of the trend.
- Not Suitable for Short-Term Trading: The Average Directional Index indicator is not suitable for short-term trading strategies, as it is designed to identify longer-term trends. Traders who use short-term trading strategies may need to use other indicators or tools to complement the Average Directional Index indicator.
It is important to note that the ADX indicator should not be used alone to make trading decisions. It is best used in combination with other technical indicators and fundamental analysis to make informed trading decisions.
ADX – Directional Movement Index For Amibroker (AFL)
range = Param("Periods", 14, 2, 200, 1 ); Plot( ADX(range), _DEFAULT_NAME(), ParamColor( "ADX color", colorBlue ), ParamStyle("ADX style", styleThick ) ); Plot( PDI(range), "+DI", ParamColor( "+DI color", colorGreen ), ParamStyle("+DI style") ); Plot( MDI(range), "-DI", ParamColor( "-DI color", colorRed ), ParamStyle("-DI style") );
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