How to use the average directional index in trading

How to use the average directional index in trading

Trend traders can use the Average Directional Index (ADX) technical indicator to spot and confirm the strength of a trend in a security, then combine the ADX reading with other indicators to determine whether it makes sense to trade with the trend. 

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Technical Indicators are charting tools that appear as lines on charts, or as other kinds of graphical information, and serve as guidelines for buying and selling opportunities. Traders use technical indicators like the ADX to make predictions about future prices. They verify how well a specific indicator works for a particular security, often by calculating the odds of success under similar market conditions to guide their actions.

The ADX normally depicts three lines in order to give traders an accurate depiction of both the strength and direction of trends: the Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), as well as the ADX lines. The DIs indicate trend direction, while the ADX depicts trend strength.

The ADX is plotted using a formula developed by Welles Wilder in the 1970s. On a basic level, it is calculated by first finding the DIs, then plotting the moving average of their absolute values. A strong trend is identified when the ADX is over 25, while a weak trend is indicated when the ADX is below 20.

Traders typically look for crossovers of the -DI and +DI lines to determine whether to make a trade. A potential buy signal is represented by the +DI line crossing above the -DI line with the ADX over 20 – or even better, above 25. The -DI crossing above the +DI with an ADX over 20 or 25 indicates a short trade opportunity. An ADX value below 20 indicates a trendless price, which most traders interpret as a less advantageous time to trade the security. ADV crossover above 40 and back below it often indicates the end or reversal of a trend.

Traders should be wary of crossovers, which can occur quite frequently and result in losses if not evaluated with other factors. False signals are more common with ADX values below 25, but reversals can also happen above that threshold.

Always remember that there is no single indicator that works well for all securities. The ADX should be used with other indicators and price analysis to mitigate risk and misleading signals.