The Average Directional Movement Index, also referred to as the ADX, a well-known technical trading tool designed by J. Welles Wilder and was introduced in his 1978 book, New Concepts in Technical Trading Systems.
The indicator in essence is derived from the smoothed averages of the difference between Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), and gauges the strength of a trend irrespective of its direction over time.
Although, the average Directional Movement Index was designed by Wilder to accommodate commodities, it can also be applied to forex.
Trading the Average Directional Movement Index Indicator
The Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI) are the backbone of the Average Directional Movement Index.
The indicator is designed in a manner that depicts the +DI and –DI as two separate lines, filled yellow green and wheat respectively.
The ADX is the third line (light sea green) on the indicator and portrays the strength of the trend.
When the wheat (-DI) line is above the yellow green (+DI) line, it is an indication of declining price.
When the yellow green (+DI) line is above the wheat (-DI) line, it is indicative of rising price action.
If the –DI and +DI lines are seen interweaving back and forth, then it is likely an indication of the absence of a trend and price is moving sideways.
Fig. 1.0
The Average Directional Movement Index precisely would not point out the path of the trend, instead its strength, and its main objective is to assess the different phase of the trend under examination.
If you take out the +DI and –DI lines, leaving behind the ADX line, you’ll be surprised to see that the ADX line alone tell us how strong the price momentum is purely.
A quick look at the Average Directional Index reveals an indicator with only a single adjustable parameter i.e. the number of periods, in which prices can be traced backward.
The default parameter is 14, as recommended by Wilder.
The Average Directional Movement Index is mathematically represented by a relatively complex formula which requires several steps to derive and it is sufficient for us to say at this point that the indicator stays positive and oscillates on a scale of 0-100.
The indicator’s values however seldom goes beyond the 60 level, where the 20 level is termed a key area distinguishing trending from choppy markets.
The higher the value of the ADX, the stronger the market trend.
We have an indicator where the +DI and –DI aids in highlighting direction, while the ADX centers on the how strong the bullish or bearish trend is.
When the ADX reading stays above the 25 level, it is signaling a strong trend, but if the ADX reading is below the 25 level, then it is signaling the absence of a trend, meaning price is either weak or moving sideways.
Understanding Basic Average Directional Movement Index Signals
The Average Directional Movement Index indicator can be used in both trending and sideways markets.
The indicator can be deployed as part of a trading system that take account of entry and exit signals, along with analytical insights.
1. Trend Strength
In its original form, the Average Directional Movement Index (ADMI) is deployed to check out whether an asset is trending or not.
This will enable a trader decide if he/she will adopt a trending or non-trending trend-following system.
Based on wilder’s recommendations, a strong trend is in place when the ADX is above the 20 level, and the market is said to be in a choppy state when the ADX is below 20 (some traders will prefer the >25 level).
Some traders believe that the area between the 20 and 25 level is a gray zone.
Technical analysts may have to tweak the number of periods on the ADX indicator to ramp up sensitivity and its alerts.
Also present within the ADX is a fair amount of lag due to the smoothing techniques that it holds.
Fig. 1.1
The chart above shows the light sea green line of the ADX indicator below the 20 level, thus depicting a non-trending market.
When the line get aligned above the 20 level, it shows a trending market state.
Notice that in the trending state No. 1, the market was bullish, while trending state No. 2 reveals a bearish sentiment.
Recollect our earlier statement, the “not point out the path of the trend, instead its strength, and main objective is to assess the different phase of the trend under examination.”
As such, the ADX line does not carry any information on the direction of the trend (see Fig. 1.1).
2. Trend Direction and Crossovers
The directional movement of the Wilder’s indicators constitute a simple trading system.
One of the first things to look out for is whether the ADX is trading above the 20 level.
This automatically implies that the market is in a strong trend. Some traders, however, deploy 25 as a key level. Initiate a buy signal when the +DI intersects the –DI to stay above.
The buy signal stays active as long at the ADX stays above the 20 level, even if the +DI intersects the –DI to stay below.
If the trend continues, traders are advised to integrate their personalized stop-loss and trailing stop.
Alternatively, a sell signal is in place when the –DI intersects above the +DI and traders can implement the high on the day’s sell alert as its initial stop-loss.
Average Directional Movement Index trading strategies for scalpers
Scalping is known to focus on minute market moves and on smaller timeframes like the 1-minute, 5-minute and 15-minute.
These timeframes ensures that the moves happen quickly, making it imperative for everyone to minimize risk exposure per trade until you have mastered consistently the art of scalping the market for profits.
Always have it at the back of your mind that faster profits does sometimes imply faster losses, but an ADX trading strategy that takes advantage of the Bollinger Bands all wrapped up on the 1-minute chart will always yield significant positive risk reward ratio i.e. winnings will always stay bigger than losses.
The strategy is an impeccable blend of the ADMI indicator which gauges the strength of a trend and the Bollinger Bands that is built to gauge market volatility.
Checkout this amazing Average Directional Index indicator (WildersDMI) scalping trading strategy here.
Average Directional Movement Index trading strategies for day traders
The ADMI index is an indicator that does pretty well at spotting strong trends, however, it is a lagging indicator.
Lagging indicators are known to perform poorly when day trading, but might work for position trading.
If you want to know whether day trading is possible with the ADMI indicator, the answer is yes.
We focus on the 5-period ADX dipping below the 25 level when day trading with the ADMI indicator.
We get ready to trade break-outs into potential new trends.
If the ADX is below the 25 level, this is a perfect pause time.
Initiate a buy break-out if the yellow green (+DI) line is above the wheat (-DI) line and the ADX line breaks above the 25 level.
A sell break-out on the other hand takes shape when the wheat (-DI) line is above the yellow green (+DI) line, plus the ADX line breaks above the 25 level.
Checkout this example of an ADX trading strategy for day traders here.
Average Directional Movement Index trading strategies for swing traders
Swing trading revolves around taking quick gains from the market.
Though similar to day trading, since investors tend not to hold positions with a long term outlook.
A swing trader is looking to hold their positions for an hour, a day or a couple of days given the opportunities offered by market forces.
We’ll deploy the ADX along with the Bollinger bands on the H4 chart as our swing trading strategy.
We allow price to test the upper and lower band of the Bollinger and as a rule, it is expected to reverse.
The strength of the reversal can be determined with the level and trend of the ADMI indicator.
See an ADX trading strategy for swing traders here to deepen your understanding.
Conclusion
The ADMI indicator is a blend of three lines i.e. –ADX, -DI, and +DI.
IF the +DI is aligned above the –DI, it depicts stronger buyer pressure.
If the ADX break above the 20 (or 25) level, it is an indication of a strong trend and the trend direction is determined by the placement above/below of the +DI and –DI lines.
Deploy a crossover trading rule to isolate the dominant trend.
Go bullish when the +DI line crosses above the –DI line, while go bearish when the –DI line crosses above the +DI line.
Use the ADX, +DI and –DI to analyze a trend once it plays out.
There are no profit targets on the ADMI indicator, and traders need to manually input such targets based on current price action.
The ADMI indicator is known to lag and a reading of 20 or 25 does not necessarily imply that a trend will happen.