Average Directional Index , ADX represents part of the system of Directional Movement Index and is based on filtration pursuant to paces of price change. Average Directional Index was first time introduced by J. Welles Wilder in 1978 in "New Concepts in Technical Trading Systems" book.
Author relies upon the point that markets cannot experience strong trends for more than 30% of time. This indicator was aimed to avoid (or decrease) losses resulted from the principle of following trend in the situation when there is no trend.
The system is equipped with a filter DMI allowing to enter the market only when a significant trend is found. Traders or investor working with DMI gets an opportunity to avoid signals in inactive market with a “flat” trend.
Directional Movement Index DMI consists of +DI and -DI indicators. In his book Wilder provided detailed instructions on its measurement and interpretation.
Average Directional Index is rendered on price chart in a separate window (below the price chart). On the picture you can see day chart GBPUSD with ADX indicator window.
Pay attention that with decline of ADX the tendency is getting weaker. Upon completion of tendency, the market turns to correction, reversal or switches to a calm phase. Usually false signals accompany decline of ADX.
Do not open trades in direction of correction. When ADX grows, we can assert strengthening of tendency, which allows opening trades in direction of current trend. Reversal of ADX from bottom to top can say about revival of the market or emergence of a new trend.
ADX figures should be of immediate interest when its value is above 20 - 22. When ADX is reversed from top to bottom, current tendency loses its intensity and probability of correctional movement or reversal grows. Therefore, when ADX enters zone of extreme values, it is important to trace a probable change of trend's direction.
Important: growth of ADX says about presence of trend but does not tell about its direction.
That is to say, ADX grows on any trend (both on ascending or descending). Decline of ADX says about absence of trend.
Direction of current trend is defined by this indicator due to other two lines of DMI system. (Lines +DI and –DI). When +DI is above –DI and ADX grows, trend is considered ascending and one can buy a contract. When +DI is below –DInd ADX grows, trend is descending and one can sell.
Developer of the indicator stated that the best possible period set in preferences is the range from 14 to 17.
Let's consider an example
In zone 1 ADX grows, in zone 2 it falls. In zone 1 one can open a trade in direction of main tendency, it is not recommended to enter the market in zone 2, and open positions should be closed.
We will have a look at DMI system (period 14) Zone 1. ADX is reversed from bottom to top, +DI line is above –DI that signalizes that new long positions can be opened. Zone 2. Line +DI is still higher than –DI, but ADX reversed that makes signals to leaving zone of purchases.
Zone 3. Line DI crosses +DI from bottom to top thereby showing that purchases can be opened, but at that ADX continues its decline, which is not confirmed by the force of descending movement. Afterwards it is apparent that the market has been situated in flat movement and opening of trades is unpromising.
Taking into account above-mentioned features of ADX indicator while creating your own trading system, it is recommended to apply it along with other technical indicators or oscillatos.