Our Trading 101 series has covered eight key indicators and tools that every crypto trader needs to know about to begin analyzing the market. In this final part, we look at the average directional index (ADX) to see what it can tell us and how it can help us.
Introduction to the Average Directional Index (ADX)
The average directional index (ADX) was designed by J. Welles Wilder Jr, creator of the Parabolic Stop and Reverse (SAR) and the Relative Strength Index (RSI), and is a technical analysis indicator used to determine the strength of a trend. It was initially created for commodity daily charts, but it can be used in other markets or timeframes, including cryptocurrency. Let’s start by finding out what the ADX is and what it can tell us.
How the ADX Works
ADX commonly includes three separate lines, or a representation of them, and are used to help assess whether a long or a short trade should be taken, or no trade at all. The trend is shown by two indicators, the Negative Directional Indicator (-DI) and the Positive Directional Indicator (+DI), while the ADX itself is a single line that runs through them. The ADX line helps investors determine trend strength, while -DI, and +DI are momentum indicators, helping determine overall trend direction. In the below example, the solid green line is the ADX while the red and green shaded areas illustrate the weight of the trend – the huge patch of green throughout May illustrates the strong uptrend, while the patch of red at the current point in time shows that down is the current trend.
The ADX identifies a strong trend as being over 25 and a weak trend being below 20, with crossovers of the -DI and +DI lines also playing an important part in generating trade signals. Using the above example, on May 5 the +DI line crossed above the -DI line and the ADX was above 25. This combination is a potential buy signal, as it proved to be. The ADX can be as low as 20 for a buy signal to be considered in this scenario, but ideally the reading should be over 25. If the -DI crosses above the +DI and ADX is above 20 or 25, as happened on July 11, this presents an opportunity to enter a potential short trade.
+DI and -DI crosses can also be used to exit current trades. For example, if currently in a long position, witnessing a cross of the -DI above the +DI could be a good sign to sell. When the ADX is below 20 the DI indicators signal that the price is trendless, it might be wise not to enter a trade and await further direction in the asset instead.
Limitations of ADX
As we can see from the above chart, crossovers can occur frequently, and sometimes they are not indicative of a trend change. These are called false signals, and they are more common when ADX values are below 25. The ADX can also sometimes reach over 25 temporarily before reversing with the price. Like any indicator, the ADX should be combined with other indicators to confirm a trend and should not be used in isolation.
That’s All Folks!
We hope you liked our Trading 101 series and found value in our overviews of the essential tools any trader needs to play the market. Of course, there is much more to learn about these indicators, and all the other kinds out there, but this should hopefully have given you a starting point to work from in your endeavors to become a crypto trading king. Good luck!