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Trading with the ADX indicator

Trend trading strategies​ often focus on trading in the direction of a strong trend, when there is clear direction of which way an asset’s price will continue. Whether the price is increasing or decreasing, if there is a clear trendline on a price chart, it could mean that the risk is relatively lower when trading.

In order to determine these price trends, traders look to use trend strength indicators, such as the ADX indicator. This technical analysis​ tool was developed in 1978 by Welles Wilder as a trend strength indicator for the commodities market, although it can be applied to all financial markets. In particular, it is effective when used in collaboration with momentum trading​​ strategies, within the share market and forex trading. This is because strong trends are generally more prominent within highly liquid (and often volatile) markets, so the trader is able to ride the price trend smoothly until it ends. The ADX indicator is one of the most popular and effective trend indicators, especially when used alongside other similar tools.

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What is the meaning of ADX indicator?

The average directional index (ADX) is indicative of the overall strength and direction of a trend. The ADX indicator takes an average of expanding price range values to show whether a security’s current price is in a bullish or bearish phase, and compares it with historical price chart​ data. The purpose of the average directional movement index is to measure the strength of a trend and create buy or sell signals, depending if the trader should go long or short on an asset.

How to read the ADX indicator

The ADX indicator is a momentum indicator that is used along with the negative directional indicator (-DI) and positive directional indicator (+DI). These directional movement indicators help to identify trend direction instead of strength, and are not always displayed on price charts. Quite often, the ADX line is plotted as a single line on a graph, with values that range from one to 100.

When the positive DMI reads above the negative DMI, this means that prices are increasing and this signals an uptrend​. When the negative DMI reads above the positive DMI, this means that prices are falling and this signals a downtrend.

The general understanding of the ADX indicator is that a reading of over 25 identifies a strong trend, whereas a reading of below 20 identifies a weak trend, and traders will often avoid trend trading strategies in this area. Obviously, the higher the score, the stronger the trend. However, a particularly high score can indicate that the asset is overbought or oversold, so traders need to take caution and look to exit the trade fairly soon, before it reaches its peak and starts to decline.

Top indicator = average directional index. Bottom indicator = directional movement index.

ADX indicator calculation

ADX calculations are based on a moving average of price fluctuations over a specific period of time. The most commonly used ADX indicator formula uses multiple calculations for the three separate lines, which is the following:

+DI = (Smoothed +directional movement ÷ ATR) x 100

-DI = (Smoothed -directional movement ÷ ATR) x 100

DX = ((+DI – -DI) ÷ (+DI + -DI)) x 100

ADX = ((Prior ADX x 13) + Current ADX) ÷ 14

Positive directional movement occurs when the current high minus the prior high equals greater than the prior low minus the current low. A negative directional movement occurs when the prior low minus the current low equals greater than the current high minus the prior high.

Although knowing the formula can come in handy, it is not necessary to measure ADX calculations yourself, as most online trading systems will calculate technical indicators​ automatically, including our own trading platform, Next Generation.

Aroon indicator vs ADX indicator

The Aroon indicator is another trend strength indicator that shares similarities with the average directional index. For example, both indicators have lines that represent positive and negative directional movement. However, the Aroon indicator has two lines in total: an ‘Aroon up’ line that measures the time period since a price high, and an ‘Aroon down’ line that measures the time period since a price low. These are used to measure both trend strength and direction, something that the ADX indicator does not offer.

Similar to the ADX, crossovers of the two Aroon lines help to provide trend signals, but as the calculations of each indicator are different, the crossovers on each indicator will happen at different time periods. Furthermore, the Aroon indicator does not have such a complicated formula, as it does not use the average true range (ATR) to smooth out the chart, meaning that it tends to react quicker to price action​ within price charts.

Top indicator = ADX indicator. Bottom indicator = Aroon indicator.

How to use the average directional movement index

Crossovers of the directional movement indicators can create trade signals for potential opportunities. For example, if the +DI line crosses above the –DI line and the ADX reading is above 20, then some traders may see this as a good opportunity to buy and go long. Alternatively, if the -DI crosses above the +DI line and the ADX reading is above 20, then they may see this as a good opportunity to sell and go short on an asset. Crossovers can be used to signal exit points as well as entry points, as well as warning traders not to enter a position until the market is more stable or profitable.

The ADX indicator is a clear indicator for momentum. A succession of higher peaks means that trend momentum is rising, whereas a succession of lower peaks means that trend momentum is falling. Therefore, the lower peaks act as a signal for the trader to ensure that their risk-management​ technique is in place, in case of a quick change in momentum. Read more about momentum trading​.

ADX indicator in forex

As we have mentioned earlier in the article, the ADX indicator is often used within highly liquid markets, and forex trading​ is arguably the most liquid financial market of them all. When applied to currency trading, the ADX indicator helps to measure the strength of a currency pair, to see whether the asset is increasing or decreasing in price. This will reflect its trend momentum and predict when the trend is starting to fade.

ADX stock indicator

The same strategy applies to the share market​ as above. Using an ADX strategy to assess the performance of stocks allows traders to see when a particular share is overbought or oversold, according to the succession of lowering peaks. The stock market can be very volatile and share prices are often influenced by fundamental factors and economic events​, such as news releases and earnings reports. This may have an effect on a stock’s price in a rapid timeframe, and therefore, it is more difficult to use technical price charts and indicators to predict the direction of a stock. For this reason, the ADX indicator and other trend-based indicators do not work as well for the share market as for other financial instruments.

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ADX indicator trading strategy

When using the ADX indicator, it can provide us with information that is missing from a basic price chart. In particular, the average directional index helps to identify support and resistance levels​, which show whether a price is staying within its trend range or if there are major price fluctuations that may lead to a breakout. Breakouts happen when there is sudden momentum of an asset’s price, which is normally due to increased supply and demand.

ADX strategies are useful for the following:

  1. Identifying when there could be a breakout
  2. Signalling an appropriate strategy for a trader to use

For example, if an ADX reading jumps to above 25, this alerts the trader of a potential future breakout, and so they may decide to short sell their positions or take a long position, depending on which way the price is heading.

What is an ADX-ADXR crossover?

A second accompanying line, the average directional movement index rating (ADRX), works alongside the ADX to measure the change of momentum. A lagging indicator, the ADXR produces trending signals after the ADX. When the ADX rises above the ADXR, a trader could interpret this as a buy signal, whereas when the ADXR rises above the ADX, a trader could interpret this as a sell signal and subsequently consider shorting their positions.

Using both ADX and ADXR crossover indicators will provide more accurate trading signals than just one, therefore, it is a good idea to explore both technical analysis tools for optimal results.

Top = ADX indicator. Bottom = ADX-ADXR crossover.

How to set up the ADX indicator

The average directional index indicator and the ADXR are both available on our online trading platform, Next Generation; all you need to do is sign up for a live account to get started. Traders are able to customise trading graphs with our technical analysis indicators and drawing tools, which makes it easier to spot trends and patterns on live price charts. Our ADX trading system is also available to access through a demo account, where you can practise first with virtual funds. This will be granted to you for free when applying for an account.

You may wish to consider your execution strategy before placing a trade. Trend trading strategies can be risky, particularly within volatile markets such as stocks and forex, therefore you should read further about our stop-loss orders and risk management tools in order to minimise your losses.

You may need to adjust ADX indicator settings based on the asset that you choose to trade. For example, although the ADX indicator can be used effectively with stocks, those with low volatility may not create enough signals based on the parameters. Therefore, it is sometimes possible to adjust the ADX settings to match the security that is being traded.

ADX indicator for MT4

As well as on our own trading platform, we host the internationally recognised trading platform, MetaTrader 4, which comes with all standard features of an MT4 account. This includes the ADX indicator for momentum and trend trading strategies. Open an MT4 account now to practise your ADX strategy with virtual funds.

Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

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