What is the ADX (Average Direction Index)?
The ADX is one of the most used and studied indicators in the world of trading. It is a trend indicator and tries to measure the strength of it to help us determine if we are in a bullish, bearish or even lateral phase.
This indicator was developed by the legendary J. Welles Wilder and presented in his 1978 work “New Concepts in Technical Trading Systems”. In this book we can also find the indicators ATR, Parabolic SAR or RSI, all developed by this guru of Technical Analysis.
Without a doubt, we are talking about an essential work for lovers of technical analysis. A work, which, by the way, still today, you can find in pdf format for free if you search on Google.
It should be noted that in its origin, in 1978, the indicator and most trading strategies were based on the futures markets of raw materials, true dominants of the trading world in those years, when there was no Forex or CFDs. What the Americans negotiated with passion was commodity futures contracts, just when they were in their hottest years.
Therefore we see that the ADR would try to measure the strength of the direction in the movement of financial assets.
The way to study this indicator would be to see it as an oscillator between the values 0 and 100, and in theory the rises of it should indicate bullish force and bearish strength, although we will see that the thing is not as clear as it seems at first view.
How to calculate the ADX?
To determine the ADX we must first calculate two other indicators that would be the + DI and the -DI.
First of all we have to determine what is the Directional Movement, DM, which can be positive (Plus) as + DM or negative (Minus) as -DM.
If we have that:
- (current maximum – previous maximum)> (previous minimum – current minimum) then we have a + DM. Otherwise we have 0.
- (previous minimum – current minimum)> (current maximum – previous minimum) then we have a -DM. Otherwise we have a 0.
- Notice how these two values only exist if the other gives 0.
The + DI (Positive Directional Indicator) would be the indicator of positive direction and it would be showing us that the movements have an upward trend.
It would come from calculating + DI = + DM / TR
+ DM would be the sum of the positive movements and TR is the True Range.
The -DI (Negative Directional Indicator) would be the negative direction indicator and it would be showing us that the movements have a downward trend.
It would come from calculating -DI = -DM / TR
For the calculation of these two values, the same period is used, which by default is usually 14 in the brokers. We can modify this period to our liking, depending on our strategy, of course.
Result of the ADX
The final ADX indicator that will try to measure the strength of the current trend comes from the following formula:
ADX = ((+ DI) – (- DI)) / (+ DI) + (- DI))
As I said before the result should give between 0 and 100 but rarely exceeds the value of 60, at least with 14 as a period. You can check this in the graphs you want in the long term.
How is the ADX presented in the brokers’ charts?
It depends on the broker or the graphics tool that we use we will see an ADX or another.
Why do I say this?
Because in many platforms or graphics, we only teach ADX by default, which from my point of view leaves this indicator orphan, since what is really interesting about it is seeing the two values + DI and -DI.
For example, in Metatrader 4 we can see the three default values, as we see in the following example, with the blue being the + DI and the red line being the -DI.
However, if we open the indicator in Tradingview we will only see the ADX by default.
Likewise, in ProRealTime we do not see the – and + DI by default, which we would have to configure separately.
In short, I advise you to have the value of the three lines so you can see a bit how they give us these possible “signals” both bullish and bearish.
Interpret the ADX to make operations
If we look at the example of the EURUSD on its daily chart we can see as if we let go of our intuition and we think that the market has to be bullish because the ADX is going up and down because the ADX is going down, we would be making a serious mistake.
Because the ADX measures us the force in which a trend is growing regardless of whether it is bullish or bearish.
In this way, we have that the ADX rose very strongly in April and May while the EURUSD went down in those months. That is, what happened here was that the ADX measured us the change of the previous “trend”, which was actually a lateral market, towards the new trend, and so this indicator “oscillated”.
Therefore, what we can see with the ADX is that it oscillates between the changes of trend or lateral markets.
That’s why I think it’s better if we look at the + DI and -DI since the crossings of them can give us the clue as to what the market really means.
In other words, if we only operate with the ADX without seeing the chart, we are not sure if the market is bullish or bearish. We are only sure when a trend or end of it has arrived, approximately.
However, with the + DI and with the -DI we will be able to check if the movement is probably bullish or bearish.
Day trading with the ADX?
If you have noticed, the author of this indicator used it with daily graphics.
In those years it was not so easy to do day trading glued to the screen all day and seeing the price live.
Most traders had to settle for calling the broker and receiving a price and that is why in the end many of them ended up trading in the medium term with daily charts.
Nowadays that is not the case and most mortals can make aggressive trading all day and even weekends with cryptocurrencies, which is why most of those who use this indicator is to do day trading in any of the financial assets.
Does ADX work for intraday?
The question is whether it works or not.
I am afraid to tell you that the vast majority of traders who try to apply this indicator in the intraday end up losing almost all their money; although this is not the only indicator with that record.
The problem is due to the dynamics of day trading that makes it very difficult to earn in the long term in a way that you can always defeat the other agents in the market, not to mention the brokers.
Let’s see an example of the EURUSD with a 15-minute chart.
In this case I have “smoothed” the indicator by setting a temporality of 30 periods because if not the amount of “signals” we would have would be brutal.
For day trading we would have to use the indicator in a similar way to the one I mentioned earlier, opening shorts when the -DI crosses over to -DI and opening longs in the opposite case.
This would be the simplest way to see the indicator.
Then you would be responsible for using different periods, from 1 to those you want and something even more important: to decide what stop and take profit, although keep in mind that this should change as the general market volatility changes.
Another way to see it would be to try to go with the market direction when the ADX (the green line) exceeds a certain level.
As we see that this indicator is usually “quoted” between 5 and 60 we could use a medium level as a “signal” point. For example the 25, a more or less “average” and very typical value.
In this example of the EURUSD of a few days we have at least six possible operations and a few more that cross but without the thing being very clear.
Here, if you notice, the first big problem of this indicator is coming, because as you can see, for example on July 19, we have to cross it several times with each other what would result in excessive “signals” , something we have to look for.
Remember that good trading is a trading with few operations but good ones, choosing when to operate at the right time.
That July 19, on the other hand, we could see how we had a very good purchase signal, the first one in particular. The clearest of all. If we limited ourselves to operating only that signal that day we could obtain a good profit, as long as we let our profits run decently, of course.
In the second example, we see how we can apply the ADX to give signals when the same “crosses” a value, like the one I said before (it could be any other).
In this case I have chosen an example in which we would probably have had great gains, because as we see in it if we have a strong trend, as in this case that was bearish, we can have several very good sales signals.
If you notice, except for the first two times the ADX crossed by 25 in which the + DI was above the -DI, the rest of the occasions we had bearish signals, with the ADX crossing 25 and the red line above the blue (“downward signal”).
If we applied good trading conditions here, we could have obtained many pips.
However, do not think that this will always be the case.
You will also have periods of side markets in which you will get important losses.
Something that would be very good to do if you want to deepen this indicator is that you learn basic programming languages and apply them to it, such as MQL4, 5, Amibroker, NinjaTrader, ProRealTime.
I think it is an indicator that has potential and if we find the perfect period together with the appropriate profit and loss taking, we could have acceptable results. Probably better the further we get away from day trading nonetheless.
Greetings and good trading.
Original article: “Cómo usar el indicador ADX para ganar en trading”