Trading Using Average Directional Index (ADX)

[tmbaru 10]

Trading in the Forex market in the direction of a strong trend lowers risk and increases profit potential. The ADX (Average Directional Index) is used in the market to establish when currency price is trending strongly. Average Directional Index is in essence the ultimate trend indicator. In this article, we will take time to examine the value of Average Directional Index as a trend strength indicator.

 

ADX calculations are usually based on the moving average of price range expansion within a stipulated time frame. ADX is plotted as a single line with various values ranging from 0 to 100 in the same window as two DMI (Directional Movement Indicator). Average Directional Index is non-directional and as such it registers trend strength by rising uptrends and downtrends.

 

Quantifying Trend Strength

 

Average Directional Index values enable traders to identify most profitable and strongest trends to trade in the currency market. ADX values are also critical for differentiating trending and non-trending conditions. A majority of Forex traders will use ADX value above 25 to indicate that the trend’s strength is good enough to allow for trend trading strategies. On the hindsight, when ADX values are below 25, many traders will avoid trend trading strategies.

Low Average directional Index is usually a sign of distribution or accumulation. When ADX values are below 25, price enters range conditions as well as price patterns becomes easier to identify. Price then moves up and down between support and resistance to find buying and selling interest respectively. Thus, from low ADX conditions the price will eventually break out into a trend.

 

The direction of the ADX line is critical fro reading trend strength. When the ADX line is rising then the trend strength is increasing as well as price of the currencies moves in the direction of the trend. On the flip side, when the ADX line is falling then the trend strength is decreasing and the currency price enters a period of consolidation or retracement. It is worth noting that there is always a common misperception that a falling ADX lines implies the trend is reversing. The truth of the matter is that a falling ADX line only shows that the trend strength is weakening but does not imply that the trend is reversing unless in special cases when there has been a price climax.

 

Trend Momentum

 

The series of ADX peaks is a visual representation of overall trend momentum. Average Directional Index clearly shows when the trend is losing or gaining momentum in the market. Momentum in its basic sense is the velocity of price. A series of higher ADX peaks shows that the trend momentum is increasing. On the other hand, a series of lower ADX peaks show that the trend momentum is decreasing. Knowing when the trend momentum is skyrocketing gives the trader confidence to let profits run. A series of lower ADX peaks is a warning to the traders to watch price and manage risk. The best trading decisions in the Forex market are made on objective signals and not from emotions.

When currency price makes a higher high and Average Directional Index makes a lower high then there is negative divergence. It is worth mentioning that divergence is not a signal for a reversal but a warning that the trend momentum is changing. Any time the trend changes character in the market then it is time to assess and manage risk.

 

Strategic Use of Average Directional Index

 

Currency price is the most important signal on a chart. Therefore it is advisable that you read price first then read ADX in the context of price. When indicators are used, they should add something that price alone cannot tell. Breakouts from a price range usually occur when there is a disagreement between buyers and sellers on price. ADX tells traders when breakouts are valid by showing when Average Directional Index is strong enough for price to trend in the market after the breakout.

Best profits come from avoiding range conditions and trading the strongest trends. ADX helps traders to identify trend conditions and also enable them to find the strongest trends to trade in.

“The trend may be your friend, but it sure helps to know who your friends are.”

[kuokam 10]

This looks like Dr Schaap's stuff or am I mistaken, Sir?

Edited April 21, 2013 by kuokam

[talond 10]

When you walk into a department store do you use an indicator do know if the esclator is going up or down ?

[tmbaru 10]

Technical indicators in essence are simply used to predict the future behavior of the market for traders to make a wise decision in their trading.

[tmbaru 10]

The “Average Directional Movement Index”, or “ADX”, indicator is a member of the “Trend” family of technical indicators.

Traders use the index to determine if a trend will extend or gradually lose its strength, valuable information when setting entry and exit levels in the forex market.

[sergso 10]

I used ADX in the past and I just couldn't figure out a way to make money from it even in combination with DMI+ and DMI-. Maybe it was just me...

[Ammeo 10]

I used ADX in the past and I just couldn't figure out a way to make money from it even in combination with DMI+ and DMI-. Maybe it was just me...

 

I used to use it on stocks trading alongside MACD and Stochastics, it wasnt that bad but i have to say my work used to be done without it using only MACD and stochastics ...

Overall after my experience over the different market asset classes, i'd say fundamentals are always more important than technicals...

[sergso 10]

I used to use it on stocks trading alongside MACD and Stochastics, it wasnt that bad but i have to say my work used to be done without it using only MACD and stochastics ...

Overall after my experience over the different market asset classes, i'd say fundamentals are always more important than technicals...

 

I agree about the importance of fundamentals but it is hard for someone to know the true fundamentals.

[tmbaru 10]

Fundamental analysis is good but I find technical analysis better.

[tmbaru 10]

Technical Analysis gives you the overall picture, is less time consuming, keeps your emotions out of trading and lets you trade the reality - without having to impose an opinion.

 

You trade the truth and that is the market price as you see it NOT what you think it should be.

 

On the flip side, fundamental analysis are usually influenced by the emotions of greed and fear. We all have the same facts to look at but we all make subjective judgements on what the facts mean.

[sergso 10]

I used to use it on stocks trading alongside MACD and Stochastics, it wasnt that bad but i have to say my work used to be done without it using only MACD and stochastics ...

Overall after my experience over the different market asset classes, i'd say fundamentals are always more important than technicals...

 

I agree but not for the next hour or even day. And deciphering importance and impact is not an easy job.