ADX is a technical analysis tool that measures the strength of a trend. It’s easy to use, but it has limitations that should be learned before you enter the live market. What is the ADX indicator, and how can you read its signals to develop an effective trading strategy? In this FXOpen article, we will tell you how to use the average directional index and avoid its disadvantages to get reliable signals.

What Is an Average Directional Index?

ADX, the average directional index or average directional movement index, is a trend strength indicator that helps traders identify when the price moves strongly in one direction so that they can enter a solid trend. The index is a part of the Directional Movement System. The system was developed by Welles Wilder to evaluate the price strength when it moves in a positive or negative direction. DI+ and DI- are primary indicators in the system, and they allow traders to identify the price direction. The ADX is used together with them more often than independently because this combination provides more reliable signals. Below, we will consider how to use the ADX with and without DI+ and DI- lines.

The average directional index formula is highly complicated, so it’s better to use the indicator on the TickTrader platform, as this places it on the chart automatically.

How to Read the ADX Technical Indicator

The index consists of a single line that fluctuates within a 0-100 range. Its values reflect the strength of market momentum. The common concept is:

If the index is below 25, there is a weak or no trend. It can fall below 25 when the price corrects within a strong trend or when the trend is near to reverse. Therefore, traders should be cautious when using this signal for trading.

If the index is above 25, there is a strong trend. The trend strength can also be divided into three stages: strong, very strong, and extremely strong. Look at the table below:

Note: It’s vital to remember that the index doesn’t reflect the trend direction, so it can fall in a bullish trend and rise in a bearish trend.

How to Use the ADX Indicator

There are several ways you can utilise the ADX system trading.

Note: Although the  standard setting of the index is a period of 14, traders can lower the period to 7 and increase it to 30. The shorter the period, the more frequent the signals are. This allows traders to open positions more often. An ADX with a longer period reduces market noise but provides delayed signals. It can be helpful to filter signals on shorter-term timeframes.

In the examples below, we use a period of 14 for an hourly chart and a period of 8 for daily and 4-hour charts. In short-term timeframes, the index can generate frequent incorrect signals, while in charts with longer periods, it may be too slow.

Trend Strength

In the chart above, the price was fluctuating, and the ADX was ranging around the 20-25 area over the second half of January. Once a downtrend started forming, the index stuck at above 25. A trader could have used this signal to open a sell position. Until the indicator fell below 20, a trader could believe the trend was in strength.

Trend Momentum

The ADX can help long-term traders to gauge the overall trend momentum. The theory assumes that when the price continues placing higher highs in an uptrend or lower lows in a downtrend, but the index forms lower highs and falls below 25, it’s a sign of a weakening trend, so the trend may reverse or pause for a while.

In the chart above, the price formed a higher high, but the indicator declined and fell below 25. After that, the trend started correcting. The signal wouldn’t work if the index declined but didn’t break below 25.

Note: If the indicator forms lower highs, it doesn’t necessarily mean that the trend is weakening. If you have a closer look at the examples above, you will notice that the indicator moves relative to recent price movements. If the price sets an extreme peak but then continues moving in the same direction but at lower levels, the ADX will decline. However, this won’t mean a trend reversal.

Range Trading

As the average directional index can reflect periods with a weak or no trend, it can be used for range trading.

The chart above shows that the GBPUSD pair was trading within a narrow range, and the indicator was fluctuating below 25. When the price broke below the lower bound of the range, the indicator was already above 25. A trader could use the ADX to confirm the reliability of the breakout.

Exit Points

The indicator can also be used for medium-term trading or for partial position closure. The theory says that once the ADX reaches its peak and declines, a trader can consider closing their position (1).

A decline in the indicator usually alerts traders to a change in the price direction. So, if a trader considers medium-term trading, it’s an opportunity to exit the market with the largest potential profit in case of a successful trade. If a trader considers longer-term trading in a solid uptrend, they can use ADX to partially close trades. Every time the indicator sets a new peak and decline, the trader can close a trade.

Note: It will require a lot of practice to find settings that allow you to limit the number of incorrect signals if you plan long-term trading. There is a free option with numerous technical analysis tools – the TickTrader platform.

In the chart above, the ADX formed two significant highs in a solid uptrend.

Trend Direction

As the ADX doesn’t reflect the trend direction, it is commonly used with +DI and –DI lines. This combination stands for the directional movement index technical analysis tool. It’s worth noticing that the ADX indicator is considered a more comprehensive tool when it’s combined with +DI and –DI lines.

The rule is: when the +DI is above the -DI, the market moves up. The average directional index can confirm the strength of the rise. Conversely, when the +DI is below the -DI, the market moves down. A rising ADX confirms the strength of the decline.

In the chart above, the +DMI (grey) was above -DMI (orange), but the index was below 20 (1). Although the price rose, it stopped soon afterwards. After that, the +DMI fell below -DMI and the average directional index rose above 25. This was a sign of a significant decline. Later, the +DMI broke above -DMI and the ADX was still above 25, so the price surged (2).

Limitations of the Average Directional Index

The average directional index is a useful tool. However, it has limitations that should be considered before you enter a live market.

It Doesn’t Work for Position Trading

Although the average directional index reflects the trend strength and a change in the trend momentum, it provides confusing signals when used on high timeframes. The ADX constantly moves up and down, so it’s challenging to identify whether the trend changes or it’s a short-term correction within it.

Also, traders may be confused when spotting a trend. As the price fluctuates within a trend, bouncing between support and resistance levels, constant changes in the ADX value may cause traders to make incorrect decisions regarding the trend direction.

It Requires Constant Changes in Parameter

Unlike indicators such as the relative strength index and the stochastic oscillator, the ADX doesn’t work equally well with a single parameter on all timeframes of any asset. Traders spend lots of time searching for the settings that will work for their unique trading strategies.

False Signals

Although some traders believe the ADX is more effective when used with +DMI and –DMI lines, others claim this combination is ineffective. First, it’s not easy to distinguish between the lines, so traders may be confused by various signals. Second, +DMI and –DMI frequently provide incorrect alerts. Still, these reasons are subjective. There are technical analysis tools that have more lines; for instance, the Ichimoku Kinko Hyo has more lines that have difficult names, but it is considered one of the most popular tools. Also, the frequency and reliability of signals can be managed by changing the settings.

You can decide on the effectiveness of the ADX indicator together with  +DMI and –DMI lines on the TickTrader platform for free.

Final Thoughts

The ADX indicator is one of the most frequently used tools for identifying a trend strength. It can’t be called the simplest, as although its signals are straightforward, a trader will need to adjust the settings to increase the effectiveness of the trading strategy. However, once you find your settings, you will be able to evaluate the trend effectively. You can open an FXOpen account to test various strategies with the ADX trend indicator.

This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.