Forex or foreign exchange is the world’s largest financial market, where participants exchange one currency for another. This market has a daily turnover of over $5 trillion, and traders use a variety of technical indicators to make informed trading decisions. One such indicator is the Average Directional Index (ADX), which measures the strength of a trend. In this article, we will explain how ADX is calculated and how traders use it in Forex trading.
What is ADX?
ADX is a technical indicator developed by J. Welles Wilder in the late 1970s. It measures the strength of a trend, which can be either uptrend or downtrend. The ADX value ranges from 0 to 100, where a value of 0 indicates no trend, and a value of 100 indicates a strong trend. In Forex trading, ADX is used to confirm the strength of a trend and to identify potential reversal points.
How is ADX Calculated?
ADX is calculated using three components, namely the Positive Directional Indicator (+DI), the Negative Directional Indicator (-DI), and the Average True Range (ATR). The formula for ADX is as follows:
ADX = 100 x (Average of the DX / Average True Range)
The first step in calculating ADX is to calculate the Directional Movement (DM), which is the difference between two consecutive highs or lows. If the current high is higher than the previous high, then the DM is positive, and if the current low is lower than the previous low, then the DM is negative. If neither of these conditions is met, then the DM is zero.
Once the DM is calculated, the next step is to calculate the True Range (TR), which is the greatest of the following three values:
1. The difference between the current high and low
2. The absolute value of the difference between the current high and the previous close
3. The absolute value of the difference between the current low and the previous close
After calculating the TR, the next step is to calculate the +DI and -DI. The formulas for +DI and -DI are as follows:
+DI = 100 x (Smoothed Positive Directional Movement / Average True Range)
-DI = 100 x (Smoothed Negative Directional Movement / Average True Range)
The Smoothed Positive Directional Movement (+DM) and Smoothed Negative Directional Movement (-DM) are calculated by taking the n-period simple moving average of the DM values. The value of n is usually set to 14, but traders can adjust it to suit their trading style.
Finally, the ADX is calculated by taking the n-period simple moving average of the DX values. The formula for DX is as follows:
DX = 100 x (|+DI – -DI| / (+DI + -DI))
The absolute value of the difference between +DI and -DI is divided by the sum of +DI and -DI, and the result is multiplied by 100 to get DX. The ADX is then calculated by taking the n-period simple moving average of the DX values.
How is ADX Used in Forex Trading?
Traders use ADX in Forex trading to confirm the strength of a trend and to identify potential reversal points. A high ADX value indicates a strong trend, while a low ADX value indicates a weak trend or no trend at all. Traders can use ADX to filter out weak trading signals and to avoid entering trades during periods of low volatility.
Another way to use ADX in Forex trading is to look for divergences between ADX and price. If the price is making a new high, but the ADX is not, it could be a sign of a potential trend reversal. Conversely, if the price is making a new low, but the ADX is not, it could be a sign of a potential trend reversal in the opposite direction.
Conclusion
ADX is a popular technical indicator used in Forex trading to measure the strength of a trend. It is calculated using the Positive Directional Indicator (+DI), the Negative Directional Indicator (-DI), and the Average True Range (ATR). Traders use ADX to confirm the strength of a trend and to identify potential reversal points. By understanding how ADX is calculated and how it is used in Forex trading, traders can make more informed trading decisions and increase their chances of success in the market.
