What is Average Directional Index (How Does It Work) • Benzinga

Investors with short-term timeframes often use technical analysis to evaluate price movement and identify trends. Fundamental analysis may not be particularly useful for traders looking to pop in and out of positions in days or even hours. But at the same time, technical tools like trend indicators frequently produce false positives. So how does a day or swing trader properly evaluate stocks? By combining technical tools to get a read on the data, traders can increase the probability of making the best possible decisions for their portfolios. One of these tools is the Average Directional Index (ADX), which measures the strength or weakness of particular trends and may help traders avoid short-term false positive signals. 

Many technical trading tools attempt to predict a change in trend or direction before the price can follow. For example, the Relative Strength Index (RSI) is a momentum indicator that tries to provide signals when a trend is about to reverse course (whether upward or downward). If an asset is overbought, it means an upward trend could be getting ready to reverse. If it’s oversold, a downtrend reversal might be on the horizon.

The ADX is a different type of momentum indicator. Instead of sending signals of impending trend changes, it tries to measure the force of a trend. It informs traders on whether the current directional movement is weak or strong. The calculation is relatively complex, but the result is a single variable indicating whether a trend is nonexistent, weak, strong or powerful (a rare phenomenon known as a power trend).

The ADX indicator can be used to evaluate not just stocks but commodity and currency prices as well. The indicator’s father is J. Welles Wilder, who traded commodities in the 1970s. When charting an asset’s price movement, the ADX employs two other variables alongside it on the chart— the Positive Directional Index (+DI) and Negative Directional Index (-DI). Together, these three lines provide information about the strength of the current price trend.

Here’s an explanation of the ADX’s calculation. The most often used timeframe is 14 trading sessions:

• Take the current high and subtract the previous high from it. This gives you the Positive DI figure.
• Then, take the current low and subtract the previous low. You’ll now have the Negative DI figure.
• Compare the positive and negative numbers. If the +DI is larger than the -DI (and more than zero), then direction movement is positive. If -DI is larger than +DI, then direction movement is negative. 

The ADX is calculated by following these steps over the 14-day trading period, measuring the differences between positive and negative directional movements, and then using the data to create a range from 0 to 100. Calculating the ADX by hand can be tedious, but thankfully a relatively simple interpretation of the indicator is available.

Since the ADX measures on a scale from 0 to 100, traders use simple guidelines to interpret trading signals. Note that these values only signify the power of a trend, not whether a reversal is about to occur.

• No discernible trend can be identified if the ADX is between 0 and 20, which could indicate an unpredictable stock or one stuck in a range.
• If the ADX is between 20 and 25, a trend may be forming, but it’s considered weak and unreliable.
• When the ADX ranges between 25 and 50, it indicates the trend is strengthening.
• An ADX over 50 is considered an extremely strong trend, often called a power trend.

Note that the ADX is not a bearish or bullish indicator. It measures the strength of the current trend, regardless of direction.

If you were to apply the ADX indicator to its stock chart and the indicator is below 20, it could mean the uptrend is weakening and buyers could be losing steam. But if the ADX comes in at 40, you may consider taking a position in the stock since it is indicating the uptrend has strength and may continue.

• Useful with other indicators: ADX can be helpful since it measures trend strength and doesn’t have a bearish or bullish slant.
• Simple interpretation: By providing a single variable between 0 and 100, the ADX indicator is relatively easy to understand.
• Suitable for multiple assets: ADX can be used when trading a variety of assets, including stocks, commodities and currencies.

• Crossing +DI and -DI lines can issue false positives: When the outer +DI and -DI lines cross, it sometimes results in a false positive signal.
• Not bearish or bullish: Some traders with bearish or bullish strategies may not find the ADX useful since they’re interested in finding a potential trend change, not the strength of the current one.
• Complex calculation: If calculating the ADX by hand, you’ll likely find the formula tedious and time-consuming. Novice traders may be better served to have the ADX automatically calculated by their brokers’ tools.

The ADX indicator typically uses price data over a period of 14 trading sessions to measure the potency of the current trend. By simplifying the calculation to a single number between 0 and 100, traders can get timely information about a range of asset prices. 

The ADX isn’t a perfect indicator and not every trader will find it efficient. Since it measures the current trend only, it isn’t useful when prices are range-bound or if traders are looking for bearish or bullish reversal signals. Using ADX in conjunction with other trading tools should give you a better opportunity for success.

Disclaimer: All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. This presentation discusses technical analysis, other approaches, including fundamental analysis, may offer very different views. Any examples provided are for illustrative purposes only and are not intended to be reflective of the results you can expect to achieve. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. 

Benzinga was commissioned for this article and is not affiliated with the moomoo app or its affiliated companies. This includes Moomoo Technologies Inc. (MTI) provider of the app and Moomoo Financial Inc. (MFI) Member FINRA/SIPC, which offers securities in the U.S. Any comments or opinions provided herein are Benzinga’s. MTI, MFI, or their affiliates do not endorse any trading strategies that may be discussed or promoted herein.