Average Directional Movement Index Technical Indicator (ADX) helps to determine if there is a price trend. It was developed and described in detail by Welles Wilder in his book "New concepts in technical trading systems".
The simplest trading method based on the system of directional movement implies comparison of two direction indicators: the 14-period +DI one and the 14-period -DI. To do this, one either puts the charts of indicators one on top of the other, or +DI is subtracted from -DI. W. Wilder recommends buying when +DI is higher than -DI, and selling when +DI sinks lower than -DI.
To these simple commercial rules Wells Wilder added "a rule of points of extremum". It is used to eliminate false signals and decrease the number of deals. According to the principle of points of extremum, the "point of extremum" is the point when +DI and -DI cross each other. If +DI raises higher than -DI, this point will be the maximum price of the day when they cross. If +DI is lower than -DI, this point will be the minimum price of the day they cross.
The point of extremum is used then as the market entry level. Thus, after the signal to buy (+DI is higher than -DI) one must wait till the price has exceeded the point of extremum, and only then buy. However, if the price fails to exceed the level of the point of extremum, one should retain the short position.
The Average Directional Index (ADX), Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI) represent a group of directional movement indicators that form a trading system developed by Welles Wilder. Wilder designed ADX with commodities and daily prices in mind, but these indicators can also be applied to stocks. The Average Directional Index (ADX) measures trend strength without regard to trend direction. The other two indicators, Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), complement ADX by defining trend direction. Used together, chartists can determine both the direction and strength of the trend.
Plus Directional Movement (+DI) and Minus Directional Movement (-DI) form the backbone of the Average Directional Index (ADX). Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between the highs.
Directional movement is positive (plus) when the current high minus the prior high is greater than the prior low minus the current low. This so-called Plus Directional Movement (+DM) then equals the current high minus the prior high, provided it is positive. A negative value would simply be entered as zero.
Directional movement is negative (minus) when the prior low minus the current low is greater than the current high minus the prior high. This so-called Minus Directional Movement (-DM) equals the prior low minus the current low, provided it is positive. A negative value would simply be entered as zero.
The chart above shows four calculation examples for directional movement. The first pairing shows a big positive difference between the highs for a strong Plus Directional Movement (+DM). The second pairing shows an outside day with Minus Directional Movement (-DM) getting the edge. The third pairing shows a big difference between the lows for a strong Minus Directional Movement (-DM). The final pairing shows an inside day, which amounts to no directional movement (zero). Both Plus Directional Movement (+DM) and Minus Directional Movement (-DM) are negative and cancel out each other. Negative values revert to zero. All inside days will have zero directional movement.
ADX = SUM[(+DI-(-DI))/(+DI+(-DI)), N]/N
- N — the number of periods used in the calculation.
The Average Directional Index (ADX) is used to measure the strength or weakness of a trend, not the actual direction. Directional movement is defined by +DI and -DI. In general, the bulls have the edge when +DI is greater than – DI, while the bears have the edge when – DI is greater. Crosses of these directional indicators can be combined with ADX for a complete trading system.
Before looking at some signals with examples, keep in mind that Wilder was a commodity and currency trader. The examples in his books are based on these instruments, not stocks. This does not mean his indicators cannot be used with stocks. Some stocks have price characteristics similar to commodities, which tend to be more volatile with short and strong trends. Stocks with low volatility may not generate signals based on Wilder’s parameters. Chartists will likely need to adjust the indicator settings or the signal parameters according to the characteristics of the security.
At its most basic the Average Directional Index (ADX) can be used to determine if a security is trending or not. This determination helps traders choose between a trend following system or a non-trend following system. Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below 20. There appears to be a gray zone between 20 and 25. As noted above, chartists may need to adjust the settings to increase sensitivity and signals. ADX also has a fair amount of lag because of all the smoothing techniques. Many technical analysts use 20 as the key level for ADX.
Wilder put forth a simple system for trading with these directional movement indicators. The first requirement is for ADX to be trading above 25. This ensures that prices are trending. Many traders, however, use 20 as the key level. A buy signal occurs when +DI crosses above – DI. Wilder based the initial stop on the low of the signal day. The signal remains in force as long as this low holds, even if +DI crosses back below – DI. Wait for this low to be penetrated before abandoning the signal. This bullish signal is reinforced if/when ADX turns up and the trend strengthens. Once the trend develops and becomes profitable, traders will have to incorporate a stop-loss and trailing stop should the trend continue. A sell signal triggers when – DI crosses above +DI. The high on the day of the sell signal becomes the initial stop-loss.
The directional movement indicator calculations are complex, interpretation is straight-forward and successful implementation takes practice. +DI and – DI crossovers are quite frequent and chartists need to filter these signals with complementary analysis. Setting an ADX requirement will reduce signals, but this uber-smoothed indicator tends to filter as many good signals as bad. In other words, chartists might consider moving ADX to the back burner and focusing on the Directional Indicators to generate signals. These crossover signals will be similar to those generated using momentum oscillators. Therefore, chartists need to look elsewhere for confirmation help. Volume-based indicators, basic trend analysis and chart patterns can help distinguish strong crossover signals from weak crossover signals. For example, chartists can focus on +DI buy signals when the bigger trend is up and – DI sell signals when the bigger trend is down.
- ADX: Base indicator line
- +DI: +DI indicator line
- -DI: -DI indicator line
- Period: Averaging period for calculation, default is 14
- Apply to: Applied price
- Median Price, (high+low)/2
- Typical Price, (high+low+close)/3
- Weighted Close, (high+low+close+close)/4