Average directional index is a useful indicator for traders to use in order to gain an objective understanding of the trend. It is a group of three directional indicators which, when applied together, can form a trading system which both defines the direction and the strength of a trend. Most indicators such as moving averages will offer an analysis of the trend direction whilst oscillators and momentum indicators can show the relative strength of a stock, currency or commodity. ADX attempts to represent both and allows traders to see, at a glance, where the market is in relation to price, momentum and direction. Although it is an incredibly useful indicator, it does tend to lag price and therefore its principal use is not as a generator of trading signals but as an analytical tool to enhance a traders understanding of the market.
The Average Directional Index (ADX) was developed by Welles Wilder in 1978 as a way for traders to measure both strength and direction of a trend. The three indicators are formulated so that the ADX indicator alone measures trend strength whilst the two other indicators compliment this and allow for the direction of the trend to be added to this. These two indicators are known as the Plus Directional Indicator and the Minus Directional Indicator.
The way that the three indicators work to produce what we see as the ADX indicator applied to charts is an analysis of current price and very recent price. The two Directional Indicators compare the differences between consecutive lows and consecutive highs to establish the direction of the trend. This means that, in order for the indicator to be seen as negative, it would require that the sum of the previous low of a given price bar minus the current low is greater than the current high minus the prior high. With negative values being shown as zero in these sums the idea behind this analysis is simply to show whether markets are more inclined to make lower lows or higher highs by comparing their relative strength.
Therefore, on a chart, the ADX can be seen as an indicator which will be most useful to show traders whether a market is trending or not. A value of the ADX of above 20 is the default signal that a trend is present. A value of above 25 would represent a strong trend and that below 20 would represent no trend at all. Todays EUR/USD, for example, shows on the hourly charts that the trend is weakening, despite price being near to the most recent highs. This is a sign for many traders that perhaps that the recent upward run may be coming to an end. As with all indicators mapping historical data there will always be some degree of time lag and, therefore, the presence of a strong trend would not be reason alone to trade using the ADX as an entry signal.
Having said this, it is not impossible to develop a trading strategy using the group of indicators forming the ADX. One of the most popular trading applications of the ADX is to use it as a complementary signal to the two other directional indicators. The strategy involves waiting until a trend is above 25, so that it may be considered a strong trend, and then watching the two directional indicators for crossovers in the direction of the ADX. So when the ADX is reading as 25+ and the plus directional indicator crosses up through the minus directional indicator this would be considered a buy signal. This very effective trading strategy was created by Welles Wilder himself and he recommended, on a daily chart, using a stop loss of the high or low of the day that the signal is generated.
The ADX is an incredibly popular indicator due to its simplicity to interpret. However, its use as a standalone signal creator is limited because of the frequency of signals that it generates. Using it in conjunction with the plus and minus directional indicators will certainly reduce this and allow for a more defined entry; however, as with most indicators its use may be supplementary to a more price-action based strategy. Despite this, the ADX does provide a more comprehensive analysis of both trend and direction unlike traditional oscillators which simply measure momentum.