ADX (Directional Movement System)

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Introduction

Traders that utilize charts for trading decision are always looking to trade with strong trends. One tool that can help them identify strong trends is the Average Directional Movement Index Indicator also called the ADX.

Anyone who has traded with technical indicators understands that some indicators work better than other in trending and non trending markets. So in order to maximize the benefit of technical indicators, the first thing you need to do is to identify what are the current market conditions. The Average Directional Index developed Welles Wilder, can be used to quantify if the market is trending or not trending. The ADX measures trend strength without regard to trend direction. The Minus Directional Indicator (-DI) and Plus Directional Indicator used together with the Average Directional Index (ADX), can tell us what direction of the current trend is and how strong the trend is.

Once the market conditions are determined you use another indicator to use in combination with the ADX improve your odds of success. The greatest value of the ADX is to help traders to identify the strongest and most profitable trends to trade.

Calculation

The ADX calculation is actually is a combination of the positive directional indicator (+DI) and negative directional indicator (-DI) which were also created by Welles Wilder. The ADX is a smoothed exponential moving average of the +DI and –DI. Smoothed versions of (+Di) and the (-DI) are divided by a smoothed version Average True Range (ATR) to define the true magnitude of a price move. With all of the steps involved in calculating the ADX, you will see that you will be better off using charting software. Traders today have the benefit of charting software and computers to calculate the ADX whereas Wilder calculated everything by hand.

ADX= N period exponential moving average of the Directional Movement Indicator (DX).

DX = (+DI - (-DI)) / (+DI + (-DI))

  1. The first thing on has to do is to determine the Directional Movement Indicator (DX), where +DM is a positive directional Movement indicator and -DM is a negative directional movement indicator.
    • Determine the delta extreme price changes from previous period:
      [Delta High] = [High] - [Previous High]
      [Delta Low] = [Previous Low] - [Low]
    • If today's trading range is entirely within yesterday's trading range, or if the trading ranges are the same, there has been no directional movement:
      if ([Delta High] < 0) and ([Delta Low] < 0) or
      [Delta High]=[Delta Low] then [+DM]=0 and [-DM]=0
    • If the trading range has moved upward, there has been a positive directional move:
      if ([Delta High] > [Delta Low]) then [+DM=[Delta High] and [-DM]=0
    • If the trading range has moved downward, there has been a negative directional move:
      If ([Delta High] < [Delta Low]) then [+DM] =0 and [-DM]=[Delta Low]
  2. Next step is to determine the Average Directional Movement Indicator (ADM), where the -ADM is the Average Negative Direction Movement Indicator for N periods and the +ADM is the Average Positive Direction Movement Indicator for N periods:
    • Exponential moving average applied to +DI:
      [+ADM] = EMA([+DI])
    • And exponential moving average applied to -DI-:
      [-ADM] = EMA([-DI])
  3. Next step is to calculate the True Range (TR) and the Average True Range (ATR). The ADX formula is complex enough so we will take a look at the TR and ATR formula in another article. For those that are curious type, the ATR is version of the two period trading range defined by Wilder.
  4. Next step is to determine the DX, where +DI is the average positive directional movement indicator normalized by the average true range and -DI is the average negative directional movement indicator normalized by the ATR:
    • [+DI] = [+ADM] / ATR * 100
    • [-DI] = [-ADM] / ATR * 100
  5. The second to last step is to calculate the DX. It is the ratio of the absolute value of difference of the +DI and -DI to the sum of the them:
    [DX] = (|[+DI] - [-DI]|) /  ([+DI] + [-DI]) * 100
  6. The final step is to calculate the ADX, where ADX is the exponential moving average to the DX:
    [ADX] = EMA([DX])
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Interpretation

In its most basic interpretation, the ADX can be used to measure the strength or weakness of a market trend. It does not provide direction of the current trend. By adding the +DI and –DI indicators, traders can see the current direction of the market.  Simplistically when the +DI is above the –DI line, the market is currently in up trend. Conversely, when the –DI is above the +DI, the market is currently in a down trend.Wilder watched for cross-over’s of the directional indicators combined with ADX to form a basic trading system. The ADX was used to identify strong trending markets and the –DI and +DI was used to identify buy and sell signals.

Trend Strength

The Average Directional Index is useful in identify trending from non trending stocks. The advantage of this it that is allows traders choose between a trend following indicators or range bound indicators. Most technicians believe that when ADX is above 25 the stock is in a strong trend. When the ADX line is below 20 then no trend is present. Many traders feel that the ADX signals are too slow due smoothing techniques employed. You can adjust the periods to increase sensitivity and signals given as opposed to the 14 period as the default used by Wilder.

DI Crossover System

The ADX Indicator alone does not provide buy or sell signals, which is why technicians use additional indicators to trade with the ADX. Wilder created a basic trading system by incorporating the directional movement indicators with the ADX index. His first pre-requisite was to use the ADX find strong trending stocks. By only trading stocks that had an ADX line above 25, Wilder improved his odds of trading in the direction of the trend. Longs were initiated when the +DI crossed above – DI line. Shorts are initiated when the - DI crosses above +DI line.

Conclusion

The ADX greatest value is not as trading indicator but as a tool to help traders identify what kind of indicators to use and when to use them. When a strong trend is identified by the ADX, traders will know that the best bet for profits is to employ trend following strategies. Conversely when the ADX indicates that the markets are currently trendless, then traders should employ momentum indicators to find profitable trading ideas.