How to Trade the Average Directional Index ADX

In our last lesson we went over Bollinger Bands, an indicator which helps traders gauge the volatility in the market as well as how high or low current prices are relative to historical prices. In this lesson we are going to learn about the Average directional Index (ADX), an indicator which helps traders determine when the market is trending, when the market is ranging, when the market may be about to change from trending to ranging or vice versa, and to gauge the strength of the trend in the market.

When plotted below the chart the ADX Line is normally accompanied by two other lines which are known as the +DI and -DI Lines.

I am not going to go into the formulas for the Indicator here however you do need to know that:

• The +DI Line is representative of how strong or weak the uptrend in the market is.
• The -DI line is representative of how strong or weak the downtrend in the market is.
• As the ADX line is comprised of both the +DI Line and the -DI Line, it does not indicate whether the trend is up or down, but simply the strength of the overall trend in the market.

As the ADX Line is Non Directional, it does not tell you whether the market is in an uptrend or a downtrend (you must look to price or the +DI/-DI Lines for this) but simply how strong or weak the trend in the financial instrument you are analyzing is. When the ADX line is above 40 and rising this is indicative of a strong trend, and when the ADX line is below 20 and falling this is indicative of a ranging market.

So one of the first ways traders will use the ADX in their trading is as a confirmation of whether or not a financial instrument is trending, and to avoid choppy periods in the market where many find it harder to make money. In addition to a situation where the ADX line trending below 20, the developer of the indicator recommends not trading a trend based strategy when the ADX line is below both the +DI Line and the -DI Line.

Another way that traders use this indicator is to identify the potential start of a new trend in the market. Very simply here they will look from below the 20 line to above the 20 line as a signal that the market may be beginning a new trend. The longer the market has been ranging, the greater the weight that most traders will give this signal.

The final example that I am going to cover on how traders use the ADX is to position to trade long when the +DI crosses above the -DI (as this is a sign that the buyers are winning out over the sellers) and to position to trade short when the +DI line crosses below the -DI (as this is a sign that the sellers are winning over the buyers). As with the other crossover strategies that we have covered used alone, the DI crossover is prone to many false signals.