Introduction
You are sitting in front of your trading screen, the market's pulse racing through the charts, and you are about to make a decision that could either skyrocket your portfolio or teach you a valuable lesson. You have heard about the Average Directional Index (ADX), a tool that professional traders use to gauge the strength of a trend. Let's take a step further and try to understand how this indicator works.
What is the ADX Indicator?
The ADX indicator is a part of the Directional Movement System, which Welles Wilder, the creator of other popular indicators such as the RSI and the Parabolic SAR, developed. The Directional Movement System has three components: the +DI, the -DI, and the ADX. The +DI and the -DI are two directional indicators showing positive and negative directional movement, respectively. The ADX is the average absolute difference between the +DI and the -DI, leading to the trend's strength regardless of direction.
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How to Calculate the ADX Indicator?
The ADX indicator is calculated using a series of steps that involve the following variables: the +DM, the -DM, the TR, the +DI, the -DI, the DX, and the ADX. Here is the explanation:
- The +DM (positive directional movement) is the difference between the current high and the previous high if it is positive and greater than the difference between the current low and the previous low. Otherwise, it is zero.
- The -DM (negative directional movement) is the difference between the current low and the previous low if it is positive and greater than the difference between the current high and the previous high. Otherwise, it is zero.
- The TR (true range) is the greatest of the following three values: the prevailing high minus the ongoing low, the absolute value of the prevailing high minus the previous close, and the absolute value of the present low minus the last close.
- The +DI (positive directional indicator) is the smoothed average of the +DM divided by the ATR (average true range), which is the smoothed average of the TR multiplied by 100.
- The -DI (negative directional indicator) is the smoothed average of the -DM divided by the ATR, multiplied by 100.
- The DX (directional index) is the absolute value of the +DI minus the -DI, divided by the sum of the +DI and the -DI multiplied by 100.
- The ADX (average directional index) is the smoothed average of the DX.
To calculate the smoothed averages, you must choose a period length, usually 14. The first value of the smoothed average is the simple average of the corresponding variable for the chosen period. The subsequent values are calculated by multiplying the previous smoothed average by the period minus one, adding the current value of the variable, and dividing by the period.
How to Interpret the ADX Indicator?
- To measure the trend's strength, look at the value of the ADX indicator. The higher the ADX value, the stronger the trend. The lower the ADX value, the weaker the trend. A standard threshold level for this value is 25. If the ADX value is above 25, it means a strong trend.
- To determine the direction of the trend, observe the values of the +DI and the -DI indicators. If the +DI is above the -DI, it shows an uptrend. If the -DI is above the +DI, it suggests a downtrend. The greater the distance between the +DI and the -DI, the stronger the trend.
Conclusion
The ADX indicator can help you achieve two primary objectives: first, to determine whether the market is trending or ranging, and second, to identify the potential trend reversals and trading opportunities. It can also help you filter out the market noise and avoid false signals, as it only responds to significant price movements. If you adjust its settings accordingly, you can use this indicator for any market, time frame, and trading style.
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