The Average Directional Movement Index, or ADX, is an indicator used in technical analysis to help determine the strength of a pricing trend. The indicator was developed by Welles Wilder as part of his Directional Movement System for commodity trading. Since then it has been used for other tradeable investments such as stocks, exchange-traded funds (ETFs), and foreign currency.
The ADX can help investors understand when to buy and sell positions. Here’s a closer look at what ADX is, how to calculate it, and the role it plays in making investment decisions.
What is ADX?
ADX shows an average of price range values that indicate expansion or contraction of prices over time — typically a period of 14 days, but, in some cases it may be calculated for shorter or longer periods as well. Shorter periods may respond quicker to pricing movements but may also have more false signals. Longer periods tend to generate fewer false signals but may cause the indicator to lag the market.
The Average Directional Index is part of Wilder’s Directional Movement System, which attempts to measure the strength of pricing trends in both the positive and negative directions, by using DMI+ and DMI- indicators. The DMI+ indicates positive directional movement, and the DMI- indicates negative directional movement. ADX is calculated as the sum of the differences between DMI+ and DMI- over time. These three indicators are often charted together.
Calculating the Average Directional Index on your own is a bit complex; it requires a series of calculations to be carried out in a specific order. Luckily, you probably won’t ever have to do it yourself — instead take a look at advanced chart settings for publicly available stock charts on websites like the Wall Street Journal . There is often an option to add an ADX or DMI overlay to the chart.
For those who are curious, here’s a look at the formulas required to calculate ADX:
+DI = (Smoothed +DM/ATR) X 100
-DI = (Smoothed -DM/ATR) X 100
DX= (|+DI – -DI|/|+DI + -DI|) X 100
ADX = ((Prior ADX X 13) + Current ADX))/14
DM = Direction Movement
ATR = Average True Range
+DM = Current High – Previous High
-DM = Previous Low – Current Low
Smoothed +/- DM = ∑14 t=1DM – ((∑14 t=1DM)/14) + CDM
CDM = Current DM
How to Interpret ADX Results
It’s possible that prices within a given market could be moving up or down within a given range without ever developing into a trend. The ADX is used first and foremost to determine whether or not an up or down trend exists in a market at all.
According to Wilder’s calculations, when ADX is above 25, it indicates a strong trend; when ADX is below 20, that indicates there is no trend.
Generally, analysts conclude that between 20 and 25 represents a bit of a gray area in which some say that a developing trend is possible. It’s also possible that prices are simply ranging back and forth rather than trending.
For those who follow ADX, an ADX between 25 and 50 may represent a moderate strength trend. A result of 50 to 100 indicates trends that are increasingly strong.
How to Read an ADX Chart
Identifying the direction of trends is relatively easy when looking at an ADX chart. A line that’s moving in the upward direction indicates a strengthening trend, while a line moving in the downward direction indicates weakening. The steeper the slope of the line, the stronger the trend.
When ADX turns down, it may be an indicator that a trend is ending, which could be an opportunity for investors to consider whether they want to continue holding a position. If ADX has been low for a period of time and begins to rise by four or five points, it may be a bullish indicator that investors should consider buying to take advantage of a potentially burgeoning trend.
Using ADX, +DMI, and -DMI in tandem can generate crossover signals that can help signal opportunities to buy or sell. For example, the +DMI line crossing above the -DMI line is a potential signal to buy when ADX is above 20.
Investors tend to use ADX in conjunction with other technical analysis indicators such as moving averages to help them analyze price movements.
ADX can be used as a momentum indicator that can signal potential reversals in trends. For example, if ADX and market price are moving in an upward trajectory together, that can indicate that prices are strongly trending higher. However, if ADX declines but prices continue to rise, it may be an indicator that the market is losing momentum and prices will turn down soon.
ADX is related to some other indicators. Here’s a breakdown of similarities and differences.
ADX vs DMI
Like ADX, DMI can be used as an indicator to help determine if the price of a security is trending and how strong that trend is. DMI does not take the direction of the trend into account.
DMI can be positive or negative. Positive DMI, or +DMI, is the difference between a stock’s high price today and its high yesterday. Values from the previous 14 days are then added up.
Negative DMI, of -DMI is the difference between a stock’s low from today and its low price from yesterday. A sum is then taken for these values for the previous 14 days.
ADX is calculated as the sum of the difference between positive and negative DMI over time.
ADX vs the Aroon Indicator
The Aroon Indicator is made up of two indicators, the Aroon-Up and the Aroon-Down. Aroon-up reflects the number of days since the last 25-day high, while Aroon-Down represents the number of days since the 25-day low.
The Aroon Indicator is similar in many ways to ADX. It’s used to identify the beginning of a trend or changes to trends, and determine whether a trend exists or if prices are just fluctuating within a range. It can also help investors determine the strength of a trend.
Higher Aroon values indicate a trend, while low values represent a weakening or nonexistent trend.
Pros and Cons of Using ADX
Like any indicator, the ADX has benefits and limitations. Here’s a look at some of the pros and cons:
|Helps identify whether a trend exists or if prices are simply fluctuating within a given range.||False trading signals can occur, for example when crossovers are happening too frequently, which can result in confusion as trades quickly shift direction.|
|Can indicate shifts in trends to help investors make buy and sell decisions.|
|When used in conjunction with +DMI and -DMI, investors can examine crossover signals to make buy and sell decisions.|
When using technical analysis to decide when to buy and sell investments, individuals may make use of a wide range of research and analytic tools, such as ADX, DMI, the Aroon Indicator, and other trend indicators.
For investors who prefer this type of hand-on approach, a SoFi Invest® brokerage account offers active investing. For others, who may prefer a more hands-off approach, SoFi Invest offers automated investing accounts — an automatically managed portfolio based on their risk tolerance and goals.
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