CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Average Directional Index (ADX) is one of the best indicators developed by J. Welles Wilder in 1978. Over the last three decades, the Average Directional Index indicator has made its way to becoming a part of most major charting software. For example, in the popular MetaTrader 4 charting software, the Average Directional Index is located under Menu > Insert > Indicators > Trend, and it is labeled as the Average Directional Movement Index.
If you are a swing trader, who likes to keep your Forex positions open for a couple of days, then Average Directional Index indicator could turn out to be your go-to indicator, if not your best friend!
Average Directional Index is better known as the trend strength indicator among professional traders because it can let you know if the prevailing trend in the market is mild, or strong, or downright extreme. As a swing trader, any information regarding the underlying strength of the trend you are trying to trade can turn out to be priceless, right?
Like a car’s speedometer, the Average Directional Index can let you know exactly how fast or slow is the market is likely to move. Moreover, besides the strength of the trend, Average Directional Index indicator can also help you identify the direction of the trend!
Well, you might be wondering why you would need an indicator to tell you if the price is going up or down because you can get that information just by looking at the chart, right?
Well, as a swing trader, you want to place your order with your Forex broker at the very start of the trend, not after the price has moved 100s of pips! The genius of Average Directional Index can come handy in this kind of situation. As a lagging indicator, the ADX cannot signal which way the market is likely to go. However, as soon as the trend starts, the Average Directional Index can indicate that a new trend is underway.
Figure 1: Average Directional Index Has Three Components: ADX, Positive Directional Indicator (+DI), and Negative Directional Indicator (-DI)
The original Average Directional Index was made up by J. Welles Wilder by combining two different indicators, and had three different lines representing three sets of data. The most important information that the Average Directional Index provides for swinging traders is the ADX line (Black line), which represents the trend strength. You can see the other two data series in the indicator window in figure 1, the Positive Directional Indicator (+DI) line (Green line) and the Negative Directional Indicator (-DI) (Red line).
You can also see several horizontal lines in figure 1, which are 25, 45, and 65 levels. These are the three ADX levels we need to consider while taking trading decisions based on the Average Directional Index indicator.
When the ADX line is hovering below level 20, you should contemplate that the asset you are trading is not trending at all. However, when the ADX reading on the indicator goes above 20, you should start to pay attention, as it indicates that a new trend is probably forming. When the ADX line goes above 25, it acts as confirmation that there is a new trend in the market. Likewise, when the ADX reading goes above 45, it indicates that there is a very strong trend in the market. Furthermore, when the ADX reading moves beyond the 65 level, it means that there is an extremely strong trend in the market.
The first thing you should understand that just because the ADX value is above 25, it does not guarantee the trend would be a reliable one. Often you will find that the prevailing trend suddenly reversed just after the ADX line crossed above 25. However, the likelihood of such event is rare. As a swing trader, you are trading in probabilities and putting your money when the odds are in your favor.
Average Directional Index helps you increase your chances of winning, but it does not guarantee a 100% success rate, okay?
Now that we are done with the “disclaimer” part, let’s take a look at an actual swing trading example using the Average Directional Index.
Figure 2: Swing Trading with Average Directional Index Confirmation
In figure 2, you can see the USDJPY touched resistance at the 110 level (horizontal red line) and then started a bearish retracement. Soon the USDJPY broke above the downtrend line and began approaching the resistance level near 110.00. During this whole time, the ADX line in Average Directional Index indicator window was declining. However, as soon as the USDJPY bulls pushed the price above the resistance, the +DI crossed above the -DI line, confirming a bullish direction. More importantly, the ADX line also crossed above the 25 level, confirming the uptrend.
As a swing trader, you probably would have placed a buy order as soon as the USDJPY penetrated above the resistance near 110.00. However, blindly entering the market every time the price penetrates a support or resistance level can backfire. By waiting for the Average Directional Index to get a trend confirmation, you can eliminate the false breakouts and increase the odds of your winning.
As a swing trader, you are not only looking for entry signals, but also a way to hold onto your positions to maximize your risk to reward ratio.
Hence, once you have placed your buy order and in the trend, you can hold on to your position for as long as the +DI (Green line) remains above the -DI (Red line), and close your position when the -DI crosses above the +DI. By doing so, you would not only have a clear entry confirmation, but as a swing trader, you can also use the Average Directional Index indicator as an exit signal.