How to Use the Average Directional Movement Index and check if the chart is trending or ranging
Technical analysis is one of the two most-common strategies that Wall Street traders use to forecast the direction of an asset.
The process is so useful such that it is now used to create expert advisors or algorithms that are responsible for a substantial part of the global market.
The Average Directional Index (ADX) is one of the most popular technical indicators used in the market today.
In this article, we will look at the best strategy for using the average directional index.
What is the ADX Indicator?
The Average directional movement index is an indicator that traders use to identify the strength of a trend. The indicator is categorized in the trending category of indicators.
It was developed by Welles Wilder, the famous trader who also developed other indicators like the Average True Range (ATR), Parabolic SAR, and the Relative Strength Index (RSI).
Like many indicators, the ADX is best-used in combination with other indicators. It is also used when the market is trending in either direction.
Average Directional Movement Index formula
In our series of technical analysis, we have said that all indicators are developed using mathematical calculations. As a trader, understanding these calculations is important, but not necessary.
The ADX indicator is made up of two main parts; the positive directional movement and the negative directional movement.
The positive directional movement (DM) happens when the current high minus the previous high is greater than the previous low minus the current low. As such, this plus DM equals the current high minus the previous high.
The negative DM happens when the previous low minus the current low is bigger than the present high minus the previous high.
How to Calculate
The process of getting the ADX starts by calculating the true range (TR), +DM, and -DM. The next step is to smooth the periodic values gotten above. This is done by dividing the 14-day smoothed DM by the 14-day smoothed true range.
You should do the same for the negative DM, then you calculate the ADX.
The first ADX is usually the 14-day average of DX. The next ADX values are calculated by multiplying the previous 14-day ADX by 13.
The 14 number is usually the default but you can change it depending on your trading strategy.
How to Use ADX Indicator
The process of using the ADX is relatively easy. All you need to do is to visually check the chart and see whether it is trending or ranging.
You should not use the ADX when a chart is ranging or consolidating.
Next, you need to check the period that is applied on the ADX. You can tweak it depending on your trading strategy.
Finally, you should apply the ADX indicator. You will see that the ADX indicator is made up of three lines: the ADX, +DI and -DI.
Read the Average Directional Index
To interpret the ADX, you should focus on the ADX line. According to Wilder, a strong trend is indicated when the ADX level is above 25. A lack of trend happens when the ADX is below 20.
A good example of this is shown on the GBP/USD pair below.
ADX in GBP/USD pair
As we have written before, no indicator is 100% perfect. Therefore, it is important that you use it in combination with other indicators.
Ideally, you should use it in combination with other trend, oscillators, and volume indicators.
External Useful Resources
- More trading ideas and charts – Tradingview
- Full lesson about Average Directional Index (ADX) – StockCharts
