Average Directional Index (ADX) is a momentum indicator created by J. Welles Wilder Jr. This indicator helps decode the strength of the trend using three lines - Positive Directional Index (+DI) line, Negative Directional Index (-DI) line, and Average Directional Index (ADX) line. Although a trader uses trend indicators such as Exponential Moving Average or Super Trend, this indicator will help us understand how strong the trend is. In this newsletter, we will breakdown the indicator to gain a comprehensive understanding and then see how to interpret this indicator.

Breakdown of the indicator

The Average Directional Index (ADX) is a technical indicator used to measure the strength and momentum of a prevailing trend. Its computation involves the derivation of the +DI and -DI lines. Without delving into the specific mathematical formulas, the +DI line reflects the bullish strength of the instrument over a defined period, typically 14 days, while the -DI line indicates the bearish strength. The ADX line itself represents the average of these directional indicators.

To clearly understand the Average Directional Index (ADX), it helps to know how the ADX line moves. The ADX line is based on the average of two other lines: +DI and -DI. When the price is going up, the +DI line usually rises while the -DI line falls. When the price is going down, the -DI line rises and the +DI line falls. The ADX line goes up when the gap between the +DI and -DI lines becomes wider. This tells us that the trend—whether upward or downward—is getting stronger. The ADX line shows the strength of the trend, not its direction.

To determine the direction of the trend, it is important to observe the relative positions of the +DI and -DI lines. When the +DI line is above the -DI line, it indicates a bullish bias. Conversely, when the -DI line is above the +DI line, it signals a bearish bias.

In summary, the ADX line reflects the strength of the trend, while the positions of the +DI and -DI lines indicate the directional bias.

Interpreting ADX values

ADX indicator values range from 0 to 100. The following are the levels of ADX and their interpretation:

These levels work on any charting method be it Candlestick, Renko, or Point and Figure. Usually, when the price is between 15 and 25, the price consolidating or not in a strong trend. Therefore, if a trader wants to trade breakouts, they must trade the breakout when it occurs when ADX is near 25 levels. For traders who want to trade pullbacks, the best time is when the ADX is between 50 and 75.

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Observe the Renko chart below of INDHOTEL on 1% (Daily). The ADX indicator is plotted below the chart. Only the +DI (green) and -DI (red) line are plotted to avoid confusion. Observe the price within the black box and the +DI and -DI lines at the same time. The black box shows the price rising steadily. At the same time, the +DI line was rising and the -DI line was falling. Observe the DI lines when the price was consolidating after this move.

Look at the Point and Figure chart below of ACE on 1% (Daily). Only the ADX line is plotted in this example along with 10 and 20 Double Moving Average (DMA). Observe point 1. The price had just started a new uptrend when the price moved above the DMA lines. At the same time, the ADX line also moved above 25 levels as marked. Subsequently, when the price started consolidating at point 2, the ADX started falling. This was because the distance between the DI lines was decreasing as well. When the price broke out of the consolidation, the ADX started rising as well.

ADX, when combined with other indicators, can be an insightful tool that helps us understand the strength of the trend, even if the trend is sideways. I hope you have learnt something new from this newsletter and found it insightful. If so, please consider sharing it with your trading friends.