In the trading world, having the right tools and knowing how to use them correctly can be the difference between success and failure. One such tool is the Average Directional Index (ADX), which is acknowledged as a fundamental indicator for assessing the strength and direction of market trends. This article explores how to best utilize the ADX indicator in systematic trading, illustrated with a practical example using gold futures.
What Is The ADX Indicator In Trading?
The ADX, or Average Directional Index, is a powerful technical analysis tool developed by J. Welles Wilder Jr. in the 1970s. It provides traders with an objective measure of the strength of a market trend, regardless of its direction, using a scale from 0 to 100. A value of 0 indicates maximum market sideways movement, while 100 indicates a strong trend. Essentially, the ADX reveals whether a market is trending strongly or merely consolidating.
Understanding the ADX requires knowing its calculation process:
Calculation of the True Range (TR): TR represents the actual price movement range during the period being used for the calculation and is a crucial element for measuring volatility;
Calculation of the Directional Movement Indicators (+DI and -DI): +DI and -DI measure how much the current bar’s range has exceeded the previous bar’s range (+DI for highs and -DI for lows). These values are divided by the current bar’s TR;
Calculation of the Directional Movement Index (DX): DX represents the difference between +DI and -DI, divided by their sum, normalizing the value on a 0 to 100 scale, indicating trend strength;
Calculation of the ADX: The ADX is then derived using an exponential moving average (EMA) of the DX over a specified period (7 bars in the example in Figure 1).
