Vacations are wonderful, relaxing, invigorating (all kinds of good adjectives), but sadly, always finite. At some point they end and return we must to our daily business. For the Forex trader, it’s back to charts, candles, trendlines, news releases, chart analysis – all those wonderful things. While I was away I did have opportunity to read a book about Forex trading in which the author made the curious observation that anyone who says that they are in this business because they love trading is a liar. Yes, I would agree that there is truth in this, as trading is like many other forms of endeavor – it’s work and requires a certain level of effort and people will typically reap what they sow. And at times it can be tough work! The choices alone that have to be made can be daunting: which pairs to trade, how many charts am I going to track, which strategy to use, how much risk to take, and so on. When I began Forex trading I downloaded an archive that had something like 1000 indicators contained in it. You can spend a lifetime trying to sort your way through a thousand different indicators, and to no avail! Happily, most of us can do well just those indicators that come standard with MT4 (or most other charting applications for that matter), but there is one that I believe doesn’t actually come with MetaTrader 4 that I would hate to be without, and that’s the ADX indicator.
The Average Directional Movement Index (ADX) is a technical indicator developed in 1978 by J. Welles Wilder (who also developed the RSI indicator) as an indicator of price strength for financial instruments. Its name can be slightly misleading in as much as it is an indicator of strength of price movement (similar to RSI) and not really price direction. This is what it looks like a recent EUR/USD chart (ADX is on the bottom panel):
Of course, when I first looked at this gibberish of squiggly lines, I just cast it aside in my pursuit for other more wonderfully magical indicators. It wasn’t until more recently that I developed more appreciation for this indicator, but more importantly, I learned how to set it up in a way which is a bit easier to read and comprehend.
The ADX is actually a combination of two other indicators also developed by Wilder, namely the positive directional index and the negative directional index (the +DI and the -DI respectively). This is a part of Wilder’s directional movement system. On the chart above, in the panel on the bottom the chart, the green line is the +DI and the red line is the -DI. I’ll go into more detail how it works a bit later, but for now notice that when the green +DI line crosses up over the red -DI line, price action trends upwards, whereas conversely, when the red -DI line crosses up over the green + DI line, price action trends downwards.
To give the chart more clarity, we need to separate the ADX line in the indicator window from the +DI and the -DI lines.
There – that’s better…much easier to understand. But how do we do that? Here’s an easy trick that works with most indicators. What we do is we simply add another instance of the indicator to our chart, and then take one of the indicator panels (the top one for instance) and set the ADX line to the background color (white). Similarly, in the lower panel, we edit the +DI and -DI colors to be the background color. And presto! Two indicator panels with different elements separated between them. The chart now has more clarity and is much easier to understand. By the way, if your charting software (I’m using MT4) doesn’t come with an ADX indicator, it’s easy to find on the web – just Google it!
That’s all for now – in part two we will look at how to use this indicator and some trading setups. Until then have a good week and good luck in the market!