What Is The ADX Indicator In Trading?

The ADX, or Average Directional Index, is a powerful technical analysis tool developed by J. Welles Wilder Jr. in the 1970s. It provides traders with an objective measure of the strength of a market trend, regardless of its direction, using a scale from 0 to 100. A value of 0 indicates maximum market sideways movement, while 100 indicates a strong trend. Essentially, the ADX reveals whether a market is trending strongly or merely consolidating.

Understanding the ADX requires knowing its calculation process:

Calculation of the True Range (TR): TR represents the actual price movement range during the period being used for the calculation and is a crucial element for measuring volatility;

TR represents the actual price movement range during the period being used for the calculation and is a crucial element for measuring volatility; Calculation of the Directional Movement Indicators (+DI and -DI): +DI and -DI measure how much the current bar’s range has exceeded the previous bar’s range (+DI for highs and -DI for lows). These values are divided by the current bar’s TR;

+DI and -DI measure how much the current bar’s range has exceeded the previous bar’s range (+DI for highs and -DI for lows). These values are divided by the current bar’s TR; Calculation of the Directional Movement Index (DX): DX represents the difference between +DI and -DI, divided by their sum, normalizing the value on a 0 to 100 scale, indicating trend strength;

DX represents the difference between +DI and -DI, divided by their sum, normalizing the value on a 0 to 100 scale, indicating trend strength; Calculation of the ADX: The ADX is then derived using an exponential moving average (EMA) of the DX over a specified period (7 bars in the example in Figure 1).

Figure 1 – ADX: Example of TR, +DI, -DI, and DX Calculation over 7 bars

How To Use The ADX Indicator For Trading Success

Oscillators and indicators are popular among discretionary traders for confirmation and signal generation for market entries and exits. However, their effectiveness is often questioned, leading to uncertainty about how to maximize their potential.

From a systematic trader's perspective, let's test the ADX, one of the most renowned indicators, to see if it can genuinely enhance trading results. Rather than using the ADX for entry or exit signals, we can test its effectiveness as an operational filter, starting with a system based on a different signal, such as a classic breakout of the previous day's highs or lows.

Testing A Breakout Strategy For Gold Futures

Here's a simple trend-following strategy on Gold Futures (symbol GC on CME). The strategy enters long or short at the breakout of the previous session’s high or low, respectively.

Using a 15-minute bar chart and historical data from 2010 to now, let’s assume trading excludes the first two hours of the session, thus starting at 8:00 PM (New York time), and avoiding the last hour and a half, thus ending at 3:30 PM. This timeframe reduction helps avoid abnormal movements at session open or close.

We'll set an initial stop loss of $1000 and a take profit of $5000, then analyze the results of this basic strategy using the metrics in Figures 2, 3, and 4.

Figure 2 – Strategy Performance Summary of the basic trading system on gold futures.

Figure 4 – Total Trade Analysis of the basic trading system on gold futures.

Even without any parameter optimization, the strategy looks promising, showing encouraging results and a rising equity line. However, a prolonged sideways period from 2015 to 2019 indicates the need for refinement. Another issue is the average trade value, averaging $71, which in some cases may not be enough to cover commission costs and potential slippage in real trading.

Using ADX To Optimize The Gold Futures Strategy Performance

Without optimizing the strategy parameters, we'll test using the ADX as an operational filter, aiming to enter the market only when the trend strength aligns with our entry logic.

Since ADX ranges from 0 to 100, with 0 indicating maximum sideways movement and 100 indicating a strong trend, we could optimize the ADX threshold level to avoid trading during strong trends (above the threshold), assuming a breakout might follow a period of sideways movement.

Figure 5 – Optimizing the ADX threshold value.

Optimization results (Figure 5) show a stable range between ADX values of 50 and 70, with average trade increasing to around $100 and net profit rising. For example, an ADX value of 60 shows a good reduction in maximum drawdown, resulting in a more stable equity line.

Figure 6 – Equity Curve of the Trading System for gold futures with ADX Filter.

Final Thoughts on Gold Futures Trading with ADX Filter

Further development could certainly enhance the strategy, but this example aims to demonstrate how a systematic trader should approach the use of indicators. Instead of applying them for entry signals, use them to filter out poor entries, as shown in this example when the trend was already strong (ADX > 60).

Until next time, happy trading!

Andrea Unger

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