How to Use ADX Indicator For Day Trading | Finowings. The Average Directional Index (ADX) is a widely used technical indicator in the world of day trading.
It plays a crucial role in helping traders identify the strength of a trend and make informed buy and sell decisions.
In this article, we will delve into the ADX indicator, its formula, and how to effectively use it to generate reliable buy and sell signals for successful day trading strategies.
What is the Average Directional Index (ADX)?
The Average Directional Index (ADX) is a momentum oscillator that falls within the family of trend-following indicators.
Developed by J. Welles Wilder, ADX measures the strength of a price trend and does not provide information about the direction of the trend (upward or downward).
Instead, it quantifies the strength of a trend on a scale from 0 to 100, where higher values suggest a stronger trend.
ADX Formula:
The ADX is derived from the calculation of two other indicators, the Positive Directional Index (+DI) and the Negative Directional Index (-DI).
The formula to calculate ADX involves the following steps:
A. Calculate the True Range (TR) – the greatest of the following three values:
Current high minus the current low
Absolute value of the current high minus the previous close
Absolute value of the current low minus the previous close
B. Calculate the Directional Movement (DM) for both upward and downward movements:
+DM = Current high minus the previous high (if positive) or 0 (if negative)
-DM = Previous low minus the current low (if positive) or 0 (if negative)
C. Smooth the +DM and -DM values using a Wilder’s smoothing function over a chosen period (typically 14 periods).
D. Calculate the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI) using the smoothed +DM and -DM values.
E. Calculate the Directional Movement Index (DX):
DX = (|+DI – -DI| / |+DI + -DI|) * 100
F. Smooth the DX values using Wilder’s smoothing function over a chosen period (typically 14 periods) to get the final ADX value.
How to use ADX Indicator for Day Trading:
A. Identifying Trend Strength:
When the ADX value is below 25, it suggests a weak or non-existent trend. In such situations, day traders might consider avoiding trending strategies and opt for range-bound or mean-reverting approaches. On the other hand, an ADX value above 25 indicates a strong trend, providing a green signal for trend-following strategies.
B. Generating Buy/Sell Signals:
ADX Crossovers: When +DI crosses above -DI, it signals a potential bullish trend, implying a buying opportunity. Conversely, when -DI crosses above +DI, it indicates a potential bearish trend, prompting a sell opportunity.
ADX Level: When the ADX value is rising above 25, it signals the strengthening of a trend. Traders can wait for the ADX to reach higher levels, such as 40 or 50, before considering trend-based entries to filter out weaker trends.
ADX Strategy:
An effective ADX strategy involves combining the indicator with other tools like moving averages or Fibonacci retracements.
For instance, traders can use ADX in conjunction with the 200-day moving average to identify long-term trends and plan their trades accordingly.
Additionally, utilizing ADX with Fibonacci retracement levels can help pinpoint potential reversal points in trending markets.
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