The “Average Directional Movement Index”, or “ADX”, indicator is a member of the “Trend” family of technical indicators. J. Welles Wilder created the ADX in 1978 in order to measure the strength of trend forces. 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.
The ADX can also be classified as an “oscillator” since the various curves produced fluctuate between values of zero and 100. The “signal” line of the indicator rarely goes above 60, but values below 20 indicate a weak trend, and values over 40 suggest a strong one. The indicator consists of three lines, one each for measuring descending and ascending trends (referred to as “DM” or Directional Movement lines), and then the “signal” line that represents the “absolute” force of either the ascending or the descending trend.
The ADX indicator is available on Metatrader4 trading software, and the rather complex calculation sequence involves the following general computations:
- Positive and negative DM indicators are developed based on the previous period’s high/low values;
- An Average DM for N periods is calculated for both positive and negative trends;
- Each Average DM is normalized by dividing it by the “Average True Range”, another indicator, to arrive at two indexes;
- A directional index is computed as an absolute value percent of the difference of the two DM’s divided by their sum;
- Lastly, a moving average of the Directional Index is calculated for N periods.
Software programs perform the necessary computational work and produce an ADX indicator as displayed in the bottom portion of the following chart:
The ADX indicator will typically have three lines of differing colors. In the example above, the “blue” line is the ADX, while the “green” line represents ascending directional movement and the “gold” line, descending. A trader must remember that the ADX “signal” line is an “absolute value”, always a positive number measuring the strength of either a positive or negative trend. The ADX is often used to determine the potential for market changes depending on the movement of values.
The next article in this series on the ADX indicator will discuss how this oscillator is used in forex trading and how to read the various graphical signals that are generated.
If the ADX moves over 20 points from its lower values, then attention is given as it approaches the 40 line.
Trading signals are generated at peaks in the ADX or crossovers of the two minor DI lines. A weakness of this oscillator is that many of the crossovers can be false signals if the currency pair is moving in a sideways fashion.
Next Article >> See an example trading strategy using the ADX Indicator >>