Introduction – What’s the ADX?
The ADX or Average Directional Movement indicator is a trend indicator that was created by Welles Wilder. It is built to measure momentum and direction of the trend, as well as asset volatility. Therefore, we expect that when the ADX value is increasing, it is indicative of a strong trend. Weak trends are characterized by lower ADX values.
Composition of the ADX Indicator
The ADX indicator has three parts.
The first two parts are known as +D1 and –D1. These are the plus and minus directional indicators. 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.
Then, there is the true range line, which is defined as the largest result possible of the difference between the highest price of a particular period and the lowest price of the same period. The standard period used in the default calculation is 1 day. Other prices can also be used in the calculation. The lowest price can be replaced with the closing price of the previous period, and the highest price of the current period replaced with period’s lowest price. The True Range 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.
How to Use the ADX Indicator in Forex Trading
Each of the components of the ADX indicator can be used to trade forex. For any trade with the ADX, make sure the value is above 25. Both the Direction lines and the True Range component of the ADX (i.e. +DI, -DI) can be used to generate a three rules trading system. These rules are known as the Crossover Rule, Extreme Point Rule and the Turning Point Rule. This strategy is a trend identification system.
a) Trend Identification
The trend identification function of the ADX is based on the crossover, extreme point and turning point rules.
The Crossover Rule is based on the crossover of the +DI on the –DI. A buy signal is seen when +DI crosses above -DI, while a sell signal is seen when +DI crosses below -DI.
The Extreme Point Rule identifies price extremes after the Crossover Rule has taken effect and uses this as a trade filter. So, if the Crossover Rule’s buy signal as shown above is triggered, the trader must wait until the price has gone above the highest price of the candle where the crossover took place. This confirms a breakout which can be used to execute the long trade. Similarly for the short trade, allow the crossover rule for the short trade to apply. Then wait for the Extreme Point rule to apply (i.e. price moves below candle low on the candle where the crossover took place). A short trade can be executed.
The Turning Point Rule incorporates the True Range line into the equation, requiring that this line must be located above the direction lines for trend continuation, or below the direction lines for trend reversal.
The price chart shows the Crossover Point, at which time the candlestick is almost like a doji. A bullish candle follows thereafter, which has a high price that is higher than the high of the crossover candle. This shows that the price action is going to be bullish and therefore it is safe for the trader to set the trade on the candle that follows. Please note that the candle on which the Extreme Point rule is checked must be allowed to close for proper assessment of the candle’s high as well as the closing price.
Traders can also check their charts to see if they can identify the setup where the Extreme Point is a low which is lower than the low of the crossover candle, thus setting up a chance to go short on the currency pair.