Definition of Average Directional Index (ADX)
Traders use the average directional index (ADX) as a technical analysis indicator to determine the strength of a trend. The trend can be up or down, which can be represented by two accompanying indicators, known as the Negative Directional Indicator (-DI) and the Positive Directional Indicator (+DI) respectively.
The three separate lines commonly included in ADX are used to help assess whether a trade should be taken long or short, or if a trade should be taken at all. ADX is typically used to identify whether the market is ranging or starting a new trend. It is worth-mentioning that ADX itself as a non-directional indicator, as the trend gets stronger, the reading of ADX gets larger regardless of whether it is an uptrend or downtrend.
Average Directional Index (ADX) Interpretation
The ADX along with -DI and +DI are momentum indicators – the ADX helps investors determine trend strength while -DI and +DI help determine trend direction. To be more specific, strong trend is identified if ADX is above 25 and weak trend when ADX is below 20, and the crosses between +DI and -DI generates potential trading signals. When +DI is above -DI and ADX is above 20, the price is moving up and it is a potential signal to buy especially when ADX is above 25. On the other hand, when -DI is above +DI, and ADX is above 20 or 25, price is moving down and there is potential opportunity to enter a potential short trade. If ADX is below 20, it may not be a good time to enter a trade as index conveys that the price is trendless.
Limitations
There are some limitations of using ADX, excessive occurrence of crossovers is one of those. When crossovers happened too frequently, false signals will be delivered and will result in confusion and potentially lead to loss in trade. This is more common when ADX values are below 25. That said, sometimes the ADX reaches above 25, however is only floating there temporarily for a short period of time and then reverses along with the price. Therefore, it would be best to combine the usage of ADX with other tools and technical indicators in order to filter signals and control risk more effectively.