Published: 22 July 2020 by Andrew
Financial markets have so many variables that if you do not use analysis tools (such as ADX indicator) it is difficult to understand their trends. Far too many traders leave their market operation at the mercy of the case and thus become overwhelmed by the unpredictability of the negotiations. In this way, only one result is obtained: large losses on capital.
Fortunately, in online trading, there are tools to keep the unpredictability of the markets under control. There are methods and strategies useful for exploiting market movements and predicting them in order to bring performance to one’s operations.
One of the easiest methods to use to read the markets and predict their movements accurately, is the use of strategies based on technical indicators. In this guide, we will introduce the use of ADX, an indicator that is very easy to read, but essential for making the right decisions at the right time in the investment phase.
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What is ADX indicator and why is it used?
ADX is one of the most famous trend indicators. Like many other indicators, it was conceived by a famous engineer with a cue for technical analysis: Welles Wilder. From the beginning its purpose was to measure the strength of the trend. Therefore, it is used with the precise intent to better identify the transition from a trend to a non-trend phase.
Thanks to ADX indicator it is possible to understand in what condition the market is at a given moment. It is important to recognize this point because when situations become congested or in the phases of sideways movement of the market, it is necessary to avoid entering the market, thus saving unnecessary risks.
When you are in front of a market asset to analyze it, it is always essential to identify the trend. Whether it’s Forex, stock market indexes or cryptocurrencies, it doesn’t make much difference. Finding out what the current trend is, is the key in order to understand the type of operation to be done and maximizing the probability of making a profit at the time of closing an operation.
But, if identifying a trend with the naked eye is very difficult, it is thanks to the indicators that becomes easy to do so. The ADX indicator is considered by many to be one of the best trend indicators, both for the ease of reading and for the excellent trading signals it is able to offer to operators.
ADX indicator explained
If Welles Wilder originally thought of target line the ADX especially for the analysis of the commodity market, analysts soon realized how effective it was also on Forex and all other financial markets. This is especially true thanks to the elements that compose it and that can be observed on its graphic representation.
Now, imagine the case where the market you are looking at is trending. Through ADX you jave the opportunity to understand what the strength of the current trend is. This is a fundamental fact, because, if the trend is weak, it means that a market reversal could soon occur, if instead the trend is strong, this is difficult to happen.
Based on these data, it becomes effectively possible to choose the the of transaction that should be done: be it a Long bullish execution, or a selling operation (called Short). But let’s explain what are the elements that make up the ADX and the indications they offer on the present condition of the market.
ADX indicator consists of 3 elements that correspond to the 3 variables through which its calculation is carried out:
- ADX: the first variable we are talking about is homonymous to the indicator itself and is called ADX, this is what suggests the strength of the current trend
- + DI: the second variable is tha one that suggest to the trader the strength of the trend in an upward direction. That is, it indicates how strong the push of buyers is on the market
- – DI: the third variable is the one concerning the bear market and indicates how strongly the price moves downwards and therefore towards the decrease. Consequently, it tells us how many sellers are pushing the market downwards
Now, what does the ADX look like from a graphic point of view? To observe it, just go to a trading platform of one of the main brokers and select it. It will thus be possible to observe the ADX and easily understand how it works.
To get an idea, you can start with the following image:
As you can see from the image, the ADX indicator is positioned below the normal price graph. In this case, it is the EUR/USD graph. The ADX variable is market in black, while in green there is +DI and in red -DI. This is the most typical representation that can be observed on almost all the platforms available on the market.
The 3 lines, that characterize the ADX, move based on price and market changes and always fluctuate within values between 0 and 100.
How to read the ADX?
As we have already mentioned, the ADX alone does not indicate the direction of the market, but only the strength with which it is moving in a given direction. To achieve our results, that is to understand the bullish or bearish force, you must also use the other signals coming from the indicator.
How does ADX indicate the strength of the market? We said that it always oscillates between the values of 0 and 100 and therefore it is one the basis of its share that it can be said whether a trend is strong or weak. For example, if the ADX moves above the value of 40, expert analysts suggest that this is a time when the market is strong and moves decisively.
In short, it is a signal that many investors are present on the market and are all pushing in the same direction: bullish or bearish. When you are above 40, the trend is very strong. Instead, when the ADX moves below the value of 20, the market trend has lost its strength and vigor.
In this case, the market is moving sideways and there are no good condition to invest. When this is the case, it is better to wait for the market to regain strength before operating again. The sideways phases are the enemy of traders because there is indecision and it becomes really difficult to understand how to operate. We are unable to understand what the next trend will be.
The situation begins to change only when the ADX indicator shows the value of 30. At that moment the market forces are beginning to channel again and the conclusion can be drawn that a new trend will soon begin. At that point, the trader must only be good at understanding what kind of trend it will be, whether it is bullish or bearish.
The calculation of variables
Let’s analyze the ADX from a technical point of view to understand why it is reliable and how its + and –DI variables are calculated. We clarify that if you decide to use the ADX indictor, you will never have to do these calculations, because they are carried out directly by the trading platform you have chosen to use. However, if you want to customize the ADX and its indications, it is important to know how it is calculated.
The ADX (Average Directional Index) was created to be a sort of hybrid of two technical indicators previously developed by Welles Wilder. It is based on two values:
- + DI (Positive Directional Indicator)
- – DI (Negative Directional Indicator)
The variable +DI, as we have already saw, is an indicator that measures the strength of the positive trend. The variable –DI instead, is an indicator of the strength of the trend in the negative sense. To obtain the above variables, it is necessary to rely on the closing prices, maximum and minimum prices recorded by the asset in previous sessions.
The closing, minimum and maximum prices, chosen by analysts generally refer to each period. The rime frame of the graph preferred by those who use the ADX indicator is the daily one. This is because the indicator performs very well for medium or short term operations.
The algorithm on the trading platform works through two calculations, which are:
- UpMove = Today’s maximum – Yesterday’s maximum
- DownMove = Yesterday’s low – Today’s low
The trader determines the number of periods that will be used for the calculation, and you get +Di and –DI in the following way:
- +DI = hundred times the Exponential Moving Average of +DM divided by the True Range exposure.
- –DI = hundred times the Exponential Moving Average od –DM divided by the True Range exposure. The moving average is then calculated on the number of selected periods.
- To calculate the ADX the most experienced traders use an equation:
ADX = one hundred timed the Exponential Moving Average of the Absolute Value of [(+DI) – (-DI)] / [(+DI) + (DI)]
How to trade with ADX indicator?
Now, we talk about the most interesting part: how to make market operations using the signals coming from the ADX indicator? In fact, the advantage of using a technical indicator for online trading lies in the fact that it provides precise indications on how, where and when to trade.
ADX signals can be used on any type of market. Forex is one of the most suitable, given that it is a high volatility market and for this reason it offers many signals if analyzed through the lens of the ADX indicator. So, for this reason, we consider the type of trading signals offered and how they present themselves.
The ADX indicator, is used properly, is able to offer rather reliable trading signals. The problem with indicators is often the fact that signal cannot always be used successfully and there is therefore a high risk of loss.
But, if the ADX is so appreciated it is precisely because it is often revealed to be true in its indications. In order to understand the best time to negotiate, it is necessary to take into account all the data coming from the indicator.
ADX indicator offers 2 types of signals:
- ADX Buy Signal: a bullish signal is obtained from the indicator when the ADX is above 25 and the +DI line exceeds the –DI line from the bottom to the top. This is a clear sign that buyers are getting the better of sellers and the market will soon grow again.
- ADX Sell Signal: a bearish signal is obtained from the indicator when the ADX is above the quota of 25 and the –DI line exceeds from top to bottom, the positive variable +DI, at this moment the signal is clear: sellers are taking over the market and there will most likely be a fall in prices.
Read also: Bollinger Bands
Making Profits with ADX Strategy: is it difficult?
If you are here and you are interested in ADX, it is certainly because you would like to use it and thus improve your trading performance. As we have just demonstrated, an ADX-based strategy is not difficult to use, just find the right time to enter the market by observing the behavior of the +DI and –DI variables.
In fact, trading strategies like this, can also be used by beginners. The problem is that they find difficult to read the different market situations and therefore to interpret when investing is really convenient and when it is not.
Our advice is to enter the market only when there are very high chances of success. When a certain margin of uncertainty is perceived, it is better to abandon the idea of starting an operation and waiting for the next favorable opportunity to arise. There is no shortage of opportunities on modern markets.
Read also: Forex Forecast
Trading with ADX indicator: do you need a high capital?
Another question that many traders ask is the right amount of capital from which to start trading. Many people tend to think that to be able to earn good profits, you need tens of thousands of euros. Only in this way would you be able to bring the desired results home.
In reality, the situation is quite different. Today, with modern online trading platforms, it is possible to invest and have excellent profit probabilities even starting from minimum capital. We are talking about only € 100, which is very often the minimum capital required in order to start trading online with the major brokers.
Using the ADS indicator as well as all the other trading indicators offered by quality brokers, it is also possible to multiply the initial 100 euro and bring it to much higher figures. Just do low-risk transactions and always close loss-making transactions immediately without waiting for the illusion os a recovery.
ADX: pros and cons
When using a technical indicator to invest, you must always remember that it can have many advantages, but often there are also some cons and weak points. You must always have them in order to increase your investment effectiveness.
ADX has one particular advantage that we must mention, ADX indicator is really very effective in technical analysis, it is certain one of the best indicators. Thanks to it, with a quick glance, you can identify the current trend as few other indicators allow you to do.
With this data at your disposal, you can think of making a market decision immediately. You can ask yourself question like: is it appropriate to enter? Can I postpone it or is it a crucial occasion? Is a trend reversal about to occur? All this and much more is answered thanks to ADX indicator.
The main lack of this trend indicator is that there is the risk of receiving late trading signals. But, this is nothing new as all the main trend indicators suffer from this problem. The sideways phases are the worst for indicators suffer from this problem. The sideways phases are the worst for indicators such as ADX, because they lead it to generate numerous false signals, this is another problem that should not be underestimated.
The best solution is therefore to use the Advantage Directional Index as a support for a whole other series of analyzes that can be done on the price. Using ADX indicator alone could be limiting, so it is better to combine it with other indicators that confirm the signals sent by it.
Furthermore, our advice is to use the ADX only when it is above the value of 30 because in that case the false signals decrease a lot.
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Now, we would like to give some money management operational advice in case you want to use ADX indicator to invest. It is essential to maintain a low profile during the investment phase.
Precisely because of the risk of false signals, one should not rely too much on the market and the capital used in the operations should be kept as low as possible.
An excellent idea is to limit the money invested to no more than 5% fo your total capital. This way you can avoid too heavy losses that cut the legs of the next investment operations.
Read also: MACD
Conclusions on ADX indicator
Regardless of the indicator used or the trading strategy you choose, only one factor counts: prudence. It should not be forgotten that markets always include an unpredictability factor, this means that even when you are sure that you are bringing the operation to profit, you can lose.
In the guide, we analyzed the ADX indicator and saw that it can become a valid ally to dominate the markets and maximize profits. For those who are unable to use the indicator, however, the right solution is to copy the best traders in the world with eToro.
It is an acronym for Average Directional Index, it is an indicator widely used in technical analysis for trading.
It is used to measure the strength of a trend, a fundamental aspect for understanding when to enter (or exit!) The market.
Usually it is integrated in all MT4 Metatraders. For example, it is also present in the Demo version of ForexTB.
We are talking about an indicator widely used by traders all over the world, it is obviously not foolproof but its indications are good.