ADX

For in-depth understanding please refer to

-Next step to share trading success by Leon Wilson

ADX Directional Movement Index

Overview

• The higher the DMI (on a scale of 0-100) the better the trend potential of a move.
• The DMI system is made up of three lines; ADX and +DI & -DI.
• DMI can be used either as a system on its own or as a filter for a trend-following indicator (i.e., Parabolic SAR).

The Directional Movement Index, DMI, is an effective and frequently used trend indicator. This system was designed by Welles Wilder Jr. and is made up of three lines:

1. The +DI indicates the up average.
2. The -DI indicates the down average.
3. The ADX, average directional movement index, shows whether a trend is in effect by smoothing the difference between the +DI and -DI.

In the example above two clear buy signals have been generated. The first could have been ignored because ADX was very close to 25 - a potential danger signal. The second was perhaps more significant, even though ADX was trending downwards. It did provide a clear indication of the beginning of a very strong move in this market.

Buy and sell signals are given when +DI and -DI cross. The time periods most commonly used in the complex formula are 10 or 14 days.

According to Wilder the DMI should be used with the ADX as a filter.

• A rising ADX line means the market is trending and a better candidate for a trend-following system.
• A falling ADX line indicates a non-trending market.
• Some traders also look for an ADX greater than 20 or 25 to confirm that the market is trending. When the ADX line starts to drop from above the 40 level, that is an early sign that the trend is weakening. A rise back above 20 is often a sign of the start of a new trend.

Signals

Generally speaking, the two main buy and sell signals generated by DMI are as follows:

• A buy signal is given when +DI crosses above the -DI line.
• A sell signal is given when +DI crosses below the -DI line.

However, some refinements are suggested by experienced traders:

• The crossing of DI lines only provides an early warning signal; other criteria must be fulfilled for the actual signal.
• The ADX should be between the upper DI line and the lower one.
• An ADX below 25 is a strong warning to avoid trading.

Wilder himself developed a refinement to take care of whipsawing (when the DI lines cross back and forth over a short period, providing unreliable signals). He called it his Extreme Point Rule.

The Extreme Point Rule is derived by noting the high or low point on the day when the +DI and the -DI cross one another. +DI determines the high or low point (if +DI is above -DI the Extreme Point is the high of the day, if +DI is below -DI, the Extreme Point is the low for the day).

The extreme point is then used for the actual buy or sell signal. For example, if the price once again rises above the Extreme Point price level you have a buy signal. If the price fails to rise above the extreme point, you should continue to stand aside. The converse holds true for sell signals.

ADXR

An additional indicator, the average directional movement index rating (ADXR), was created by Wilder as a measuring tool for the strength of ADX. ADXR is the average of the current ADX and the ADX 14 days ago. ADXR is typically plotted alongside ADX on the same chart.

-Never trade a Long position when the DI-is greater than the DI+.

-Never trade a Short position when the DI + is greater than the DI-

-Directional movement is not a stand alone technique.

The ADX is an oscillator that fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend and high readings, above 40, indicate a strong trend. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend. A reading above 40 can indicate a strong downtrend as well as a strong uptrend.

ADX can also be used to identify potential changes in a market from trending to non-trending. When ADX begins to strengthen from below 20 and moves above 20, it is a sign that the trading range is ending and a trend is developing.

When ADX begins to weaken from above 40 and moves below 40, it is a sign that the current trend is losing strength and a trading range could develop.

Positive/Negative Directional Indicators

The ADX is derived from two other indicators, also developed by Wilder, called the Positive Directional Indicator (sometimes written +DI) and the Negative Directional Indicator (-DI).

When the ADX Indicator is selected, SharpCharts plots the Positive Directional Indicator (+DI), Negative Directional Indicator (-DI) and Average Directional Index (ADX). With the Red, White and Green color scheme on SharpCharts, ADX is the thick black line with less fluctuation, +DI is green and -DI is red. +DI measures the force of the up moves and -DI measures the force of the down moves over a set period. The default setting is 14 periods, but users are encouraged to modify these settings according to their personal preferences.

In its most basic form, buy and sell signals can be generated by +DI/-DI crosses. A buy signal occurs when +DI moves above -DI and a sell signal when -DI moves above the +DI. Be careful, though; when a security is in a trading range, this system may produce many whipsaws. As with most technical indicators, +DI/-DI crosses should be used in conjunction with other aspects of technical analysis.

The ADX combines +DI with -DI, and then smooths the data with a moving average to provide a measurement of trend strength. Because it uses both +DI and -DI, ADX does not offer any indication of trend direction, just strength. Generally, readings above 40 indicate a strong trend and readings below 20 a weak trend. To catch a trend in its early stages, you might look for stocks with ADX that advances above 20. Conversely, an ADX decline from above 40 might signal that the current trend is weakening and a trading range is developing.