Crypto Basics Crypto Metrics

Average directional index (ADX)

The Average Directional Movement Index (ADX), created by Welles Wilder in 1978,  is an indicator used by traders to establish the trend direction and the strength of a trend. The ADX is one of the crucial instruments used for technical analysis in securities or cryptocurrency trading. Its primary goal is to determine when the price is trending strongly. It is frequently regarded as the most accurate trend indicator.

This article will explain the Average Directional Index (ADX), how to use it, and the advantages and disadvantages of using this technical analysis tool.

What is the Average Directional Index

The Average Directional Movement Index is an indicator used by technical traders to identify the strength of a bearish or bullish trend. The ADX indicator has three separate lines because two other indicators accompany it, the negative directional indicator (-DI) and the positive directional indicator (+DI). These lines aid traders in determining whether to enter a long or short position or stay off the market. 

How to Calculate the ADX

The ADX indicator has three lines: +DI (green line), -DI (red line), and ADX (black line). These lines are calculated using the formulas below:

  1. +DI = ((Smoothed MA + DM)/ATR) * 100
  2. -DI = ((Smoothed MA – DM)/ATR) * 100
  3. DX = ((+DI – -DI)/(+DI + -DI)) * 100
  4. First ADX = sum n periods of DX / n
  5. After that ADX = ((Prior ADX * n-1) + Current DX) /n

Where:

+DM = Current High – Previous High

-DM = Previous Low – Current Low

ATR = Average True Range

N = Number of periods used in the calculation (It’s usually 14)

How to Interpret the ADX 

The ADX is a momentum indicator that helps investors determine the strength of a trend, and +DI and -DI helps determine the direction of the trend. 

  • ADX below 20: weak trend,  market is not trending;
  • ADX above 20: forecasts that a new trend is beginning. Traders can start placing sell or buy orders in the trend’s direction.
  • ADX between 20 and 40: a growth between 20 and 40 is considered a confirmation of an emerging trend.
  • ADX above 40: very strong trend.
  • ADX crosses 50: extremely strong trend.
  • ADX crosses 70: Power Trend.

Crossovers: When the +DI line crosses over the -DI line, it indicates that the market is experiencing a greater pace of positive price change than negative price change. When this occurs, and the ADX is above 25, it is a reliable sign that purchase orders should be placed. Similar to this, it indicates that the market’s rate of negative price change is greater than its rate of positive price change when the -DI crosses over the +DI line. This is a solid sell signal if it occurs when the ADX is below 25, which is the case. Crossovers are a trigger for trade management and exit just as much as they are for trade entry. 

Breakouts: In the market, breakouts are common and offer good potential for profits. Breakouts are easy to notice, but it’s difficult to determine if a breakout is valid or is a fake breakout. Fake breakouts always happen, and they tend to trap traders in bad trading positions. The ADX indicator helps the investor or trader validate the breakout. For instance, when the price moves in a new direction and the ADX reading is over 25, it suggests that the momentum can continue. However, a breakout with an ADX value below 25 may not be long-lasting.

Using the ADX as a Divergence Indicator

The ADX indicator can also be used as a momentum divergence indicator that can signal a trend change. Negative divergence happens when the price makes a higher high and the ADX indicator makes a lower high. Divergence typically signals a shift in trend momentum rather than a trend reversal. In that situation, reducing the stop-loss, putting your position on break even, or taking partial profits may be the trader’s best course of action.

Note: If the trend character changes at any time, manage your risk because divergence can result in trend continuation, consolidation, correction, or reversal.

Advantages and disadvantages of ADX Indicator

Advantages 

  • A perfect tool to measure trend strength and direction. 
  • It helps investors identify and confirm a trend breakout. 
  • It can be used in swing trading and day trading.
  • The ADX indicator can combine with indicators like the Aroon indicator, RSI, stochastic oscillator, or exponential moving averages

Disadvantages

  • It’s a delayed indicator that follows the price.
  • In shorter time frames, it is more likely to give false signals due to unexpected volatility.
  • The data it provides is insufficient to make an investment decision, so it must be combined with other technical indicators. 

Limitations of the ADX Indicator 

Crossovers and false breakouts can happen too frequently, causing traders to enter bad positions and potentially lose money on trades that quickly go the other way. These false signals frequently happen in the ADX indicator when the value is below 25. Like in all indicators, the ADX should be combined with other indicators to understand better what is happening in the market. 

The Bottom Line 

The ADX indicator is one of the best and more reliable directional movement indicators to determine the strength of the market trend and direction. The indicator helps the investor choose suitable points to enter and exit the market without getting caught in a false breakout or market lateralization. Like all technical indicators, combining ADX with other indicators is the best way to understand the market situation. Always remember to have a trading strategy with proper risk management.

face it, trading any market can often be a difficult and risky endeavor. This is especially true for the crypto market. Day traders, swing traders and long-term investors need all the useful information and tools they can get. Glassnode, the crypto industry’s leading blockchain data and intelligence platform, equips investors and traders with the most comprehensive on-chain insights to help them make better investment and trading decisions.

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