Good day everybody,

Welcome to CryptoGod-1's blog on all things crypto. Today we are going to continue the series on Technical Analysis and why it can be such an important asset for new or experienced traders. In this series I am covering some of the different Technical Analysis and Indicators which can be used to help determine market movement and sentiment when trading. For Part VI the focus will be on The Average Directional Index (ADX).

 

 

The Average Directional Index (ADX)

The ADX is an indicator developed by Welles Wilde which is generally used to show the strength of a trend in the market. It is made up of three lines, known as the positive (+DI) and negative (-DI) directional indicators, along with the trendline. According to its creator, the trend is strong when the value of the ADX is above 25, while the trend is weak or the asset is trendless when the value is below. By making use of the ADX indicator a trader can determine whether a trade should be taken long or short, or if they should even make a trade at all.

 

 

Calculating an ADX

There are a number of steps involved when calculating the ADX due to the multiple lines involved. Below I have listed out the general steps for making this calculation, along with the legend for what each symbol means:

 

Legend

DM = Direction Movement

CDM = Current Directional Movement

ATR = Average True Range

PH = Previous High

PL = Previous Low

CH = Current High

CL = Current Low

DM = Directional Movement

DI = Directional Indicator

TR = True Range

DMI =Direction Moving Index

ADX = Average Directional Index

 

• To calculate the +DM and the -DM, along with the true range, a set period needs to be taken. Generally this is set at 14 candles.
• +DM = current high - previous high. (CH - PH)
• -DM = previous low - current low. (PL - CL)
• Make use of the +DM when the current high - previous high is greater than the previous low - current low.
• Make use of -DM when the previous low - current low is greater than the previous high - current high.
• The TR is the greater figure out of the current high - current low, the current high - previous close, or the current low - previous close.
• Next the 14 period averages of the +DM, -DM, and the TR need to be smoothed. 
• The first 14TR is the sum of the first 14 TR readings.
• The next 14TR value is the first 14TR - (previous 14TR/14) + current TR.
• Divide the smoothed +DM value by the smoothed TR value which will give the +DI value, which should then be multiplied by 100.
• Divide the smoothed -DM value by the smoothed TR value to get the -DI value, which should then be multiplied by 100.
• The direction movement index (DMI) is +DI minus -DI, then divided by the sum of +DI and -DI (absolute value) before multiplying the answer by 100.
• The ADX is achieved by calculating the DX values for 14 periods or more, and then smoothing the results to get the ADX.
• The first ADX = sum of 14 periods of DX / 14
• After that, the ADX = [(prior ADX * 13) + current DX) / 14

 

 

​+DI = { (ATR Smoothed +DM) / ATR } ×100

-DI = { (ATR Smoothed -DM) / ATR ​} ×100

DX = { (+DI - -DI) / (+DI + -DI​) } ×100

ADX = { (Prior ADX×13)+Current ADX ​} / 14

 

 

How to use an ADX

The three lines of the ADX, known as the negative directional indicator (-DI), and positive directional indicator (+DI) are momentum indicator, are all momentum indicators. These are used to help investors determine the strength of a trend, while the -DI and +DI will help to determine the trends direction. 

To identify a strong trend, the ADX needs to be above the value of 25. When the trend is weak, the value for the ADX will be below 20. To make an even clear determination of a trend and its strength, traders make use of the -DI and +DI crossing over to generate trade signals. When the +DI line crosses above the -DI line and the ADX is above 20, or ideally above 25, then that is a potential signal to enter a long trade. At the same time if the the -DI crosses above the +DI, and the ADX is above 20 or preferably 25, then that is an opportunity to enter a potential short trade.

Traders can also make use of crosses to signal when to exit a trade. Simple rules to follow are when the -DI crosses above the +DI during a long trade it is time to exit the trade. Alternatively, when the +DI cross above the -DI during a short trade it can signal a time to close the trade. Traders should also be aware that when the ADX is below 20 it generally means the asset is not in a trend and it may not be a good time to enter a trade.

 

Below is an example of the ADX in use along with a candlestick chart taken from https://finbold.com/wp-content/uploads/2022/03/Screenshot-2022-03-16-at-11.34.50-1024x643.jpg
The chart shows the moments when the +DI and the -DI crossover to signal bullish and bearish signals. The ADX line is used to confirm the strength of the trends as they change from bullish to bearish, and when looking at the candlestick chart above the signals did confirm changes in the trend.

 

 

Limitations of an ADX

A limitation of using the ADX is that crossovers can happen very frequently with the lines. Due to this it can result in confusion and potentially lead to losses on trades which go the wrong way. These are known as false signals and are very common when the ADX values are under the 25 level. Along with this there is also the risk of the ADX reaching the 25 level or above and only remain there temporarily before a reverse happens along with the price. Due to the ADX being a trend indicator, it is important to combine it with other indicators to assist in filtering out any false signals and have more control management. 

 

 

Conclusion on using an ADX for TA

As a trader, whether it be day trading or long term trading, using the ADX can be very beneficial in confirm the strength of a trend. It makes use of three lines, the positive (+DI) and negative (-DI) directional indicators along with the trendline and is a momentum indicator. These lines are used to determine the strength along with the values they reach. A value over 25 indicates a strong trend, while a value below 20 indicates a weakening or trendless asset. It should not be used as a standalone indicator, instead it should be used in conjunction with other indicators to give stronger results and more reliable signals.

As stated whether you are experienced or new, Technical Analysis can always be a useful asset when trading. Just remember it is not guaranteed and nobody can predict the future, no matter how certain you believe the patterns to be. It is always just another tool of the trade to help make more informed decisions when trading. It can be easy to get caught into false signals with too many crossovers in the ADX, or if the ADX value goes above 25 or below 20 only to change direction soon after.

It is important to use ADX indicator along with other TA to get the correct signals for understanding the strength of a trend. Always zoom out, if trading on a 15 minute chart check the 1 hour or 4 hour or even 1 day chart to give you a better idea of the overall trend strength via the ADX, along with the signals and if a crossover of a larger trend is due to take place compared to a short term trend.

 

 

You can find the previous parts to the series here:

Technical Analysis - Part I - Exponential Moving Average (EMA)

Technical Analysis - Part II - Relative Strength Index (RSI)

Technical Analysis - Part III - Bollinger Bands (BB)

Technical Analysis - Part IV - Moving Average Convergence Divergence (MACD)

Technical Analysis - Part V - On-Balance Volume (OBV)

 

I hope this post was beneficial and of some use, and I plan on continuing the series with the next instalment focusing on the The Aroon Indicator. Of course each technical analysis provides different beneficial information, so combining your most trusted and favourite ones can be the best strategy for finding entry and exit points when trading.

 

Have a great day.

Peace. CryptoGod-1.

 

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