ADX Indicator Explained (Average Directional Movement)

Definition of the Average Directional Movement (ADX) Indicator:

The Average Directional Movement indicator, also known as ADX, is classified as a trend indicator. It was developed by J. Welles Wilder.

Being a trend indicator, the ADX is created to measure the trend of the market, as well as the extent to which a currency pair is trending. It therefore measures the direction of the trend, the momentum of the trend (irrespective of direction) and the volatility of the currency pair. Stronger trends are associated with higher ADXs values, while weaker trends have lower ADX readings.

adxindex

The ADX is made up of three components. These components are:

  1. The true range
  2. Minus directional indicator (-D1)
  3. Plus directional indicator (+D1).

Let us explain these different components.

The true range (TR) is the largest possible result of the difference between period high and the period low (usually one day is used as the standard period). It could also be the result of the difference between period price high and closing price of the previous period, or the difference between the period’s lowest price and the previous closing price period. The TR is always a positive value, which means that the smaller of the two figures used to derive it must be deducted from the larger figure.

The minus directional indicator (-DI) is obtained by using the minus directional movement (-DM) of the previous and current period’s low prices, as well as the highest prices of the previous and current periods.

-DM = lowest price of previous period – lowest price of current period

The plus directional indicator (+DI), is based on the plus directional movement (+DM), and the high prices for the previous and current periods.

+DM = previous period high – current period high

Usage of Indicator

The ADX indicator can be used in the following ways:

  1. The ADX can be used in conjunction with the Direction Indicator (+DI, -DI) to produce an complete trading system. This system uses three rules: the , the Extreme Point Rule, Crossover Rule, and the Turning Point Rule.
  2. The ADX can also be used as a component of trading strategies involving other indicators.

Indicator Settings

The indicator is a trend indicator. To attach it to the MT4 chart, click on Insert -> Indicators -> Trend -> Average Directional Movement. The settings shown below are the default settings for the indicator.

adding adx indicator mt4

In terms of appearance, some modifications to the look of the indicator can be made either by thickening the lines or by changing the colours for better visual clarity.

Once the ADX indicator has been attached to the chart, further editing of its properties can be done by calling up the indicator on the Indicator List (Ctrl + I). The indicator is a native indicator to the MT4 platform.

Usage of the Alligator in Forex Trading

How is the Alligator indicator used in trading forex?

a) Trend Identification

The ADX can be used to identify and trade the trend on its own using the three rules earlier mentioned.

The Crossover Rule, which is the commonest way the ADX is used to detect the trend, is to go long when +DI crosses above -DI, and to go short when -DI crosses above +DI.

The Extreme Point Rule, which is basically a breakout trade rule, aims to identify the extremes of price when the lines cross, and to use this as the trigger for the trade. If +DI crosses above -DI, the trader waits for the price to push above the price high on the candle the cross took place (the extreme point) on a subsequent candle. If +DI crosses below -DI, then the extreme point is the low price on the candlestick located where this cross occurred. Allow the price action to break below this extreme price on the next candle before entering short.

b) Trading the ADX with Other Indicators

The Turning Point Rule requires the ADX true range line to be located above both +DI and –DI. When the ADX goes below this area, this is a sign of market reversal. So this rule requires the trader to have another strategy in place. This is why this rule is listed here.

Ordinarily, the trend is assumed to be  strong when ADX is >25. If it < 20, then the asset is range-bound. When using the ADX with other indicators, you consider the following:

  1. Is the currency pair trending or range-bound (detected by the ADX true range line)?
  2. What is the direction of the +D1/-D1 cross?

When these questions are answered, you can then use the other indicators in your strategy to make the trade call.

Long Trade Entry

A typical long trade setup is shown below. We have a combination of a signal from the Parabolic SAR indicator and the ADX.

  1. ADX is >25, so we are sure the trade will trend and won’t get stuck in a range.
  2. The +D1 crosses above the –D1, which is a long trade signal.
  3. We wait for when the Parabolic SAR indicator shows a bullish signal (dots below candlestick), and we make the long trade entry as shown below.

ADX1_long

Short Trade Entry
The short trade parameters are as follows:

  1. ADX is >25, so we are sure the trade will trend and won’t get stuck in a range.
  2. The +D1 crosses below the –D1, which is a short trade signal.
  3. We wait for when the Parabolic SAR indicator shows a bearish signal (dots above candlestick), and we make the short trade entry as shown below.

ADX1_short

Make sure you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management.

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