What is the Average Directional Index (ADX)?

Average Directional Index (ADX) is a famous technical tool used by traders to determine the strength of a price trend. Welles Wilder has developed it and the average directional index ADX is a part of a broader system called the Directional Movement System. In ADX there are three separate lines, which are used to understand if a trade should be taken for long or short, or if a trade should be taken at all. In this blog we will explore everything about the average directional index, the average directional index formula, how it works, its advantages, disadvantages and a lot more.

Working of Average Directional Index Indicator

The working of the average directional index indicator starts by measuring the strength of a trend for a specified period, usually 14 periods. This is done by comparing the highs and lows of price movements. In ADX, there are three important components of the ADX line, +DI (Positive Directional Indicator), and -DI (Negative Directional Indicator). The +DI (Positive Directional Indicator) shows the upward strength of a trend and the -DI (Negative Directional Indicator) shows the downward strength of a trend.

If the +DMI is moving above the -DMI then the prices are moving up, and the ADX measures the strength of the uptrend. However when the -DMI is above the +DMI then the prices are moving down, and ADX measures the strength of the downtrend.

The main purpose of using an average directional index strategy is to filter out noise and non-trending periods. This helps traders to make decisions during periods of clear trend strength.

Average Directional Index (ADX) Formula

The Average Directional Index (ADX) formula is designed to quantify the strength of a market trend. Here's how the calculation process works.

1. Calculate +DM (Positive Directional Movement): Calculate the positive direction movement using this formula:  +DM=Current High−Previous High
2. Calculate -DM (Negative Directional Movement): To calculate the negative directional movement use this formula: −DM=Previous Low−Current Low
3. Calculate the True Range (TR): The True Range largest of the current high - current low, current high - previous close, or current low - previous close.
4. Smooth the +DM, -DM, and TR Values: To smooth the 14-period averages of +DM, -DM, and TR—the TR formula is: Smoothed TR=Previous TR−(14 Previous TR​)+Current TR
5. Calculate the Directional Indicators +DI and -DI: To calculate the directional indicators you have to divide the smoothed +DM and -DM values by the smoothed TR, then multiply by 100: +DI=(Smoothed TRSmoothed +DM​)×100 −DI=(Smoothed TRSmoothed -DM​)×100
6. Compute the Directional Index (DX): The DX measures the absolute difference between +DI and -DI: DX=(+DI+−DI∣+DI−−DI∣​)×100 
7. Calculate the ADX: The ADX is the moving average of the DX over a set period (typically 14 periods): ADX=14(Previous ADX×13)+Current DX​

The average directional index formula will help traders to understand the strength of a trend. One thing to note here is if ADX is higher then it shows a stronger trend regardless of its direction. 

How to use the ADX Indicator

Following are the ways to use the average directional index ADX:

• Identify the trend strength: ADX helps traders understand when the market is trending. If the ADX values above 25 then it indicates a strong trend and if it values below 20 then it shows a weak trend. 
• Confirms entry and exit points: To identify the buy and sell signals you can look for crossovers between +DI and -DI. A crossover of +DI above -DI suggests a buying opportunity, while a crossover of -DI above +DI indicates a selling opportunity.
• Avoid trading in non-trending markets: You should avoid following the trend strategies when the ADX is below 20 because at this time the market doesn’t have a clear direction. 
• Use ADX with other indicators: Combining the ADX with other indicators like RSI or Moving Averages can provide more reliable information. 

Advantages and Disadvantages of the ADX Indicator

The following are the advantages and disadvantages of the average directional index indicator.

Conclusion 
To measure the strength of a market trend, the Average Directional Index can be a powerful tool. The tool doesn’t mention the direction of a trend but it provides useful information on whether the market is trending strongly or weakly. Traders can make great decisions by combining the tool with other tools and strategies. However, it is best to use this tool as a part of a comprehensive trading plan rather than its own. Additionally, you can use a share market app to make more informed decisions and to track all your trading strategies.