Lesson 26 – The Average Directional Index

In our last lesson we went over Bollinger Bands, an indicator which helps traders gauge the volatility in the market as well as how high or low current prices are relative to historical prices. In this lesson we are going to learn about the Average directional Index (ADX), an indicator which helps traders determine when the market is trending, how strong or weak a trend is, and when a trend may be about to start or reverse.

Example of the Average Directional Index (ADX)

I am not going to go into the formulas for the Indicator here however you do need to know that:
• The +DI Line is representative of how strong or weak the uptrend in the
market is.
• The –DI line is representative of how strong or weak the downtrend in the
market is.
• As the ADX line is comprised of both the +DI Line and the –DI Line, it does not indicate whether the trend is up or down, but simply the strength of the overall trend in the market.

As the ADX Line is Non Directional, it does not tell you whether the market is in an uptrend or a downtrend (you must look to price or the +DI/-DI Lines for this) but simply how strong or weak the trend in the financial instrument you are analyzing is. When the ADX line is above 40 and rising this is indicative of a strong trend, and when the ADX line is below 20 and falling this is indicative of a ranging market.

Example

So one of the first ways traders will use the ADX in their trading is as a confirmation of whether or not a financial instrument is trending, and to avoid choppy periods in the market where many find it harder to make money. In addition to a situation where the ADX line trending below 20, the developer of the indicator recommends not trading a trend based strategy when the ADX line is below both the +DI Line and the –DI Line.

Example

Another way that traders use this indicator is to identify the potential start of a new trend in the market. Very simply here they will look from below the 20 line to above the 20 line as a signal that the market may be beginning a new trend. The longer the market has been ranging, the greater the weight that most traders will give this signal.

Example

Another way traders use the ADX is as a signal of trend reversals. When the ADX is trading above both the +DI line and the –DI line and then turns lower this is often a signal that the current trend in the market is reversing and traders will position themselves accordingly:

Example

The final example that I am going to cover on how traders use the ADX is to position to trade long when the +DI crosses above the –DI (as this is a sign that the buyers are winning out over the sellers) and to position to trade short when the +DI line crosses below the –DI (as this is a sign that the sellers are winning over the buyers). As with the other crossover strategies that we have covered used alone, the DI crossover is prone to many false signals.

Example