Technical analysis hinges on a great many formulas to contextualize market movement and volatility. The ability to identify patterns, create context and quantify volatility gives traders the edge as they choose to open or close positions at just the right time. One of the most important and useful tools for technical analysis is the Average Directional Index (ADX).

ADX was the invention of famed technical analyst J. Welles Wilder as part of his Directional Movement System. Wilder sought to quantify the strength of a trend based on price movement and create a metric for showing that movement. His ADX metric contextualized trend momentum as a numeric value and established parameters for when a trend breaks out, as well as in what direction it’s likely to move. 

Here’s a closer look at ADX, how it works and why it continues to be one of the most relied-upon technical analysis tools for more than 40 years. 

ADX Represents Market Trends

The Average Directional Index is actually comprised of three parts, with the ADX itself as the most important. The ADX is the mean representation of a trend’s strength, plotted on a scale from 0 to 100. 

According to Wilder, any number below 20 means the asset is absent a trend. Traders can ignore any perceived signals until the ADX broaches at least 20. Between 20 and 25 represents a forming trend, with the trend solidified as the ADX crosses above 25. Figures from 25 to 100 represent the relative strength of the trend (higher is stronger).

Traders using ADX should watch for the figure to break 25, then monitor its ebb and flow above that point. Continued increases signal a trend that’s gaining momentum; downturn back toward 25 indicates a calming trend. 

Directional Indicators (DI+ and DI-)

While ADX represents the formation and growth of market trends, two directional indicators provide context for whether that trend is bullish or bearish. 

• The Positive Directional Indicator (DI+) signals price appreciation
• The Negative Directional Indicator (DI-) signals price depreciation. 

These two lines represent previous highs and lows: the true range for the asset. Over time, they gain and lose value, resulting in a widening or narrowing of the directional indicator lines. As these lines get closer together or cross each other, it’s a sign for traders to enter or exit a position. 

Use in conjunction with the ADX, directional indicators provide traders with insight into which direction the trend or pattern will play out. This can be useful in assessing breakouts at the culmination of a pattern, for example. 

Most trading platforms offer simple overlays for directional indicators and the ADX, since the formula for Average Directional Index is quite complex. 

Signals to Watch Out For

As a trend indicator, the Average Directional Index offers traders a useful visual for understanding patterns and trend momentum. As such, there are a few simple indicators that will inform traders of when to enter or exit a position:

• When the ADX itself goes above 25, it signals a trending market
• If DI- crosses the DI+, it’s a bearish trend signal
• When DI+ crosses the DI-, it’s a bullish signal

A basic example of ADX trading might include something like the following, as outlined by a commodities investment:

Melissa is tracking gold and sees the DI- move above the DI+ on her ADX chart. She waits for the ADX itself to break above 25 and chooses to short gold on a bearish trend. She continues to track the market for two weeks. During that time, the ADX reaches 48 and hovers around that level, while the DI- begins to converge with the DI+. When the two get close to crossing again, the ADX begins to fall: her signal to exit the position.

In this example, the trader looks for the trend to level out and weaken, and chooses to sell when the directional indicators begin to exhibit reversal. The same would hold true in a long position, with the directional indicators reversed. 

Pitfalls to Using ADX

The biggest drawback of using ADX is that it’s prone to throwing out false signals. While the ADX itself tends to provide a clear representation of trend momentum, directional indicator crossovers can happen if the stock is especially volatile. These quick crossovers might trigger buy or sell signals, without being indicative of a true pattern. False signals are common and potentially devastating to traders who are too quick to jump on them. 

Likewise, pouncing on a trade as soon as the ADX broaches 25 is risky, since corrections can quickly force it back under that threshold. Traders need the discipline to wait for trends to develop, and to check potential trends against other technical benchmarks before opening or exiting a position. Price analysis is often the best way to contextualize movements that seem erratic. 

Made For Commodities, But Broadly Applicable

The Average Directional Index (ADX) was originally conceived to help identify patterns for commodities traders. However, today it’s widely adopted by all types of traders, regardless of the asset. Many traders still use it to track commodities, though it’s more widely used for tracking the trend and momentum of individual securities. 

Used in conjunction with other technical analysis tools like Average True Range and Relative Strength Index, ADX provides at-a-glance context for traders seeking to determine the ideal entry and exit positions from trending assets. And while it’s not a bulletproof analytical tool, it’s one of the most reliable in terms of establishing both trend strength and direction.