Definition
The Average Directional Index (ADX) is a technical analysis indicator designed to quantify the strength of a trend in the financial markets. Developed by J. Welles Wilder, the ADX is represented as a single line that ranges from 0 to 100, accompanied by two directional indicators: the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). The ADX is typically employed by traders to determine whether to enter a long or short position, or whether the market is too volatile or trendless to engage.
ADX vs Other Trend Indicators
| Aspect | Average Directional Index (ADX) | Moving Average |
|---|---|---|
| Primary Purpose | Measures trend strength | Identifies trend direction |
| Components | ADX, +DI, -DI | Single or multiple averages (SMA, EMA) |
| Interpretive Output | Ranges from 0 to 100 | Directions (upward, downward) |
| Lag | Moderate (smoothing factor) | Often slower (depends on average type) |
| Market application | Works well in volatile markets | Best for trending markets |
Formula
The Average Directional Index (ADX) is calculated using the following steps:
- Calculate the True Range (TR) for each period.
- Identify the Directional Movement (+DM and -DM) for the period.
- Calculate the Average +DM, Average -DM, and TR over the desired period (commonly 14).
- Finally, use the following formula to get the ADX:
\[ \text{ADX} = \left( \frac{\text{Average of the absolute values of } (+DI - -DI)}{\text{Average True Range}} \right) \times 100 \]
Where: \[ +DI = \left( \frac{\text{Average of } (+DM)}{TR} \right) \times 100 \] \[ -DI = \left( \frac{\text{Average of } (-DM)}{TR} \right) \times 100 \]
Related Terms
- True Range (TR): The greatest of the following: current high less the current low, the absolute value of the current high less previous close, and the absolute value of the current low less previous close.
- Directional Movement (+DM and -DM): Indicators derived from shifts in prices to determine the trend direction.
Fun Facts & Humorous Insights
- Welles Wilder’s Wisdom: “If you can’t stand the heat, stay out of the trading room.” – A reminder about the importance of knowing when trends rise and fall!
- Did You Know? The ADX doesn’t indicate the direction of the trend, just the strength! It’s like a referee in a boxing ring: they can tell you who’s hitting hard, but they’re not in the ring telling you who’s winning!
- Historical Anecdote: Wilder developed the ADX during an era when eating cotton candy at the fair was the most volatile thing you could experience! 🎡
Frequently Asked Questions
What does it mean if the ADX is above 25?
This indicates a strong trend, suggesting that traders might want to consider entering a position.
What happens when the ADX is below 20?
It suggests a weak or trendless market, similar to watching paint dry—unless you’re really into that sort of thing! 🎨
Can the ADX indicate the direction of the trend?
No, the ADX tells us the strength of the trend only, not its current direction. You need +DI and -DI for that information.
Online Resources for Further Learning
- Investopedia - Average Directional Index
- StockCharts - How to Use ADX
- Book Recommendation: “New Concepts in Technical Trading Systems” by J. Welles Wilder, the must-read book that introduced ADX!
