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.
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.
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.