The Average Directional Index: Is This Forex Trend Indicator for You?

by Tom Black
The Average Directional Index: Is This Forex Trend Indicator for You?

The best way to improve returns is to move in the direction of the flow and the trend. Any indicator that lets you assess the trend and find out whether it is trending strongly or not is an indicator worth knowing about. Today, we look at one such indicator, the Average Directional Index, and find out exactly what you can (and can’t) do with it. 

What is the average directional index (ADX)?

The trend strength is quantified by the ADX. It is measured based on the averages of price values that keep expanding over time. The trend can be in any direction depending on the ADX value, and it helps to establish its strength. It involves the use of two additional indicators -DI and +DI. These allow traders to determine how viable trade is and whether to go short or long. 

What is the average directional index

Let’s talk about what this indicator tells us: 

  • A trend is considered strong when the ADX is more than twenty-five, and there is no trend below twenty-five. 
  • The trend may be dissipating if the ADX falls from a high value. 
  • When the ADX is falling, it could mean that the present trend is weakening, and the market is not following a clear direction. 
  • After some time of staying low, if the ADX starts climbing up by 4 or 5, then it is a signal to start trading the present trend. 
  • A strong trend is indicated by a rising ADX. The slope of the trend is proportional to the ADX value, which means that the ADX slope is directly linked to an accelerated price movement. 

How to use the average directional index

The most important piece of information on any chart is the price. That is why first, one should read the price and then see what the ADX is saying in the context of the price. An indicator is only useful when it tells us what the price, by itself, cannot. 

For instance, some of the most effective indicators tell us that strong trends come out only when the price has been consolidating for some time. Similarly, the supply and demand balance tips over when there is a discord between the market players on the price, which leads to breakouts. The momentum of a price is only made up of the difference between these two. 

It is not hard to spot such breakouts, but many times they don’t lead to anything and end up as a trap. The ADX, however, confirms whether the breakouts are of any validity whenever it is high, pointing to the fact that a trend may be on the cards after a breakout. If the value moves from minus twenty-five to plus twenty-five, it is a strong clue that the trend is about to occur.

On the other hand, it can take some hard work to know when the price has moved from a trend to a range. But, the ADX will draw the traders’ attention to the trend weakening and the price beginning to enter into a period of consolidation. This takes place when the ADX falls from plus twenty-five to minus twenty-five. The trend is always sideways in a range, and it shows there is a broad-scale accord between the players. 

As a strategy signal, the ADX can work wonders, especially when it is taken in the context of the price. Use the ADX firstly to know whether there is a trend and find out the right strategy to use for that condition. Entries can be made on pullbacks in such conditions and taken in the trend direction. 

Measuring trend strength

To ascertain if the trend has the strength to continue, look out for the +DI crossing above the –DI. The uptrend is indicated if the slope is curving upwards. A strong trend is represented by a steep curve. The DI is positive when the present high minus the previous high is more than the previous low minus the present high. It is one of the key elements used in calculating the ADX and is shown in the graph below. 

Measuring trend strength

The other important element in calculating the ADX is –DI. Look out for the –DI moving above the +DI, as this indicates the start of a downtrend. A downtrend is represented by a slope curving downwards. The strength of the downtrend is represented by the steepness of the curve. The DI is negative when the previous low minus the present low is more than the present high minus the previous high. It is highlighted by the graph below:

The other important element in calculating the ADX is –DI

Limitations of the average directional index

The crossing over of the DIs takes place often. It can even be said that they happen too often and result in confusion, which could lead traders to potentially lose money on trends that end up going the other way. These are generally called false signals. Such signals frequently occur when the ADX is under twenty-five. Sometimes, the ADX may be more than twenty-five, but it doesn’t stay there long enough, and there is a reversal in the price. 

As is the case with any other indicator, the ADX should be taken together with price analysis and even other indicators that can filter out the noise and help you control the risk that you’re taking. 

The bottom line

Avoiding range conditions and trading trends that are strong leads to high profits. The ADX is one indicator that lets you identify and analyze the trends conditions and figure out which trends are the strongest.

Being able to do so gives a trader a clear edge in the market. Since it also helps one know the range conditions, traders won’t fall prey to the trading price that is moving sideways. It is easily the one indicator that traders should take time out to learn and implement.

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