The ADX explained simply

ADX stands for Average Directional Index. It also comes from J. Welles Wilder in 1978. It answers a question many other indicators take for granted: is there a trend at all, or is the price just moving back and forth?

What it's about

Below the price you see three lines. The ADX shows strength, +DI the push upwards, −DI the push downwards. When the ADX is above 25, the trend counts as pronounced. Below 20, as weak or absent.

An example: the ADX rises to 40 and +DI is above −DI. That means there's a strong uptrend. If the ADX rises to 40 but −DI is on top, there's a strong downtrend. The ADX itself looks the same in both cases.

How it's calculated

First you compare each day with the day before. If today's high rose more than the low fell, the move counts towards +DI, otherwise towards −DI. Both are smoothed over 14 days and divided by the average daily range. The ADX is then a smoothed average of how far apart +DI and −DI are.

With numbers: +DI is at 30, −DI at 10. The gap is 20, the sum 40, so the ratio is 50 percent. If that lasts a while, the ADX moves towards 50.

What signals traders read from it

• Trend filter: Many only use trend followers like the MACD when the ADX is above 25, and reversal signals like the RSI when it's low.
• +DI crossing −DI: When +DI rises above −DI, some read it as a buy signal.
• Rising ADX: An ADX climbing from below 20 to above 25 shows a new trend forming.

Where it misleads you

A high ADX says nothing about direction. If you read a rising ADX as a buy signal, you'll sometimes buy right into a crash. The chart shows this: during the drop the ADX rises just as it does in the later rise.

The ADX is also smoothed twice and therefore slow. By the time it rises above 25, a good part of the trend has often already happened. And when it starts to fall, that only means the trend is weakening, not that it's reversing.

An example trade with made up numbers

Felix has €10,000 in his account and risks at most €150 per trade. On a stock, the ADX rises above 25 and +DI is well above −DI. Felix buys at €55 and sets his stop loss at €52. With that distance, he buys 50 shares for €2,750. Costs: €1 each to buy and sell, plus about 2 cents of spread per share on each order.

If it works: The trend continues and Felix sells at €61. Felix is €300 ahead. After €2 in fees and €2 in spread, €296 is left.

If it goes wrong: The ADX starts falling, the trend fades and the price crumbles. The stop fills at €51.90. That's a €155 loss, €159 with costs.

The ADX showed Felix that a trend was there. How long it would last, it couldn't tell him.