Average Directional Index

An Average Directional Index (ADX) is a technical indicator used by investors, traders, and analysts to measure the strength of a particular trend. It was initially created for commodity charts but has been implemented in different capital markets over time.

The average directional index indicator moves in two directions, upward and downward, and consists of two supporting indicators, a Positive Directional Indicator (+DI) and a Negative Directional Indicator (-DI). The utility of the index lies in its ability to support the study of markets to make trading/investment decisions on whether to take a long or short position.

• The Average Directional Index (ADX) is a technical indicator to gauge the strength of a trend with respect to the price of an asset in capital markets. It was proposed by J. Welles Wilder in 1978.
• The ADX has two supporting indicator lines—Positive Directional Indicator (+DI) and Negative Directional Indicator (-DI).
• Traders must interpret signal crossovers effectively and filter unnecessary signals to make appropriate trading decisions.
• While both ADX and Aroon Indicator help gauge trends in capital markets for various assets, Aroon Indicator gives input about trends and direction, unlike ADX.

The Average Directional Index is a technical indicator used by traders and investors in different capital markets, such as those dealing in stocks, commodities, mutual funds, currencies, etc. It was introduced by J. Welles Wilder Jr., a mechanical engineer and a well-known technical analyst. The concept was published in his book New Concepts in Technical Trading Systems in 1978. It is a three-line indicator traders use to take a position; it is also called the Directional Movement Index (DMI).

The average directional index meaning defines the strength of an asset's price trend. Both direction (upward/downward) and strength are assessed in the given market conditions. A similar indicator, called the Aroon Indicator, was created by Tushar Chande.

Per the average directional index definition, the ADX measures the strength of a trend, irrespective of the direction in which it is moving. It represents the strength of a trend in numerical terms. However, it is non-directional in the sense that it does not indicate where the trend itself is headed. It uses price movements as primary data to calculate the ADX value.

The charts show a gray zone between the ADX values of 20 and 25, which usually represents a trend development. However, since it does not distinguish between upward and downward movement, traders seek additional information in the form of crossovers. The changes seen in the Positive Directional Indicator (+DI) and Negative Directional Indicator (-DI) also help them make decisions. An important aspect of the ADX is the smoothing process, which enables traders to arrive at accurate trend movements. It usually takes up to 14 periods of data to reach true ADX values.

According to ADX, when the positive directional line crosses the negative directional line, traders might consider it a buy signal as the market seems bullish. However, trading decisions are typically made based on other factors such as price action, other market indicators, etc.

Traders often employ technical indicators and techniques to ensure good trading decision-making through effective strategizing and reduce the risk of loss in capital markets. Despite using varied indicators, traders must strive to derive suitable conclusions based on the results of their analysis to avoid loss-making situations as far as possible.

This technical indicator is also used to measure the strength of trends in the cryptocurrency market. The high, low, and close prices of a cryptocurrency are used to estimate the index. One of the key advantages of employing this indicator in the crypto market lies in estimating and controlling volatility through periodic monitoring and making trading decisions after eliminating incorrect signals.

Many traders find this technique useful, but the real question is how to use it to ensure reliable results that support trading decisions. In this section, let us study how a trader can apply it in practice.

• The average directional index meaning indicates that traders can use the moving average of price movement of any trading vehicle, from stocks to commodities and Exchange-traded Funds (ETFs).
• The default time setting is 14 bars, but a trader can adjust it per their requirements.
• When the chart is prepared, only a line is drafted with values ranging from 0 to 100.
• Once the single line is plotted, the other two supporting lines, the Positive Directional Indicator (+DI) and Negative Directional Indicator (-DI), are also drawn on the same window or chart. These two supporting lines serve as an indicator of the said trend.
• If the Positive Directional Indicator (+DI) line is above the Negative Directional Indicator (-DI) line, it signifies that the price of the financial vehicle is increasing, also referred to as an Uptrend.
• Similarly, the Negative Directional Indicator (-DI) line above the Positive Directional Indicator (+DI) line represents a decline in price, called a Downtrend.
• A 0 to 25 ADX value means a weak or absent trend, but a value fluctuating between 25 and 50 is considered strong. Similarly, 50 to 75 and 75 to 100 are strong and extremely strong trends, respectively.

In this section, let us study some examples explaining this concept.

Example #1

Suppose Kaley, a trader, uses an average directional index formula for suitable trading and investing decision-making. The step-by-step calculation helps her calculate in the following manner:

Taking the moving average for a set period (typically 14), she calculates the (+) line and (-) line along with the true range of each period.

• (+) line = current high - previous high
• (-) line = previous low - current low
• True range = current high - current low

• She divides the 14-day (+) movement by the 14-day true range to derive the 14-day (+) directional indicator and multiplies it by 100 for decimal movement.
• Similarly, she divides the 14-day (-) movement by the 14-day true range to derive the 14-day (-) directional indicator and multiplies it by 100 for decimal adjustment.
• Now, she subtracts the (+) directional value from the (-) directional value divided by the sum of the 14-day (+) movement and 14-day (-) movement multiplied by 100 to calculate the directional movement index.
• Finally, she calculates the ADX by the 14-day average of the directional index in which the ADX represents the trend's strength.

The average directional index strategy may look simple, but the calculations are complex. Therefore, Kaley must ensure correct interpretation and proper implementation through adequate practice. The crossovers between the positive and negative directional lines are frequent, and Kaley must follow effective signal filtering.

Example #2

A TradingView post highlights trends related to Tesla, Inc., with a user interface being created to measure ADX in conjunction with Vortex Indicator. The aim is to give analysts a better view of where the company’s stocks are headed based on the rigorous interaction between ADX and Vortex. Given below is a representative chart of the movements seen on Nasdaq.

Source

Both the ADX and Aroon Indicators help analyze trends in markets. However, there are certain differences between these concepts.

• ADX indicates the strength of a trend. On the other hand, the Aroon Indicator shows a trend's strength and direction.
• The average directional index strategy was developed in 1978, whereas the Aroon indicator was introduced in 1995.
• The default setting of the moving average for ADX is 14 bars, but in the case of the Aroon Indicator, it typically accounts for 25 data periods.
• ADX reading between the values of 20 and 25 indicates a developing trend. However, per the Aroon Indicator, a trend can be determined at 50, with values above 50 reflecting strong trends (upward) and a downward trend seen by values below 50.

This has been a Guide to what is Average Directional Index. Here, we explain how to use it, its examples, and comparison with Aroon indicator. You may also have a look at the following articles –

• Average True Range
• Trend Following
• Momentum Trading