Average Directional Movement Index Technical Indicator (ADX)

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".  Interestingly Wilder, an engineer, is also credited with creating two other well-known technical indicators, the Relative Strength Indicator (RSI) and the Parabolic SAR which are standard indicators in most charting software packages today.

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.

Applying ADX

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.

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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.

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Positive/Negative Directional Indicators

The ADX is derived from two 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 Default 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 smoothes 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.

The Average Directional Index (ADX) and SharpCharts

With SharpCharts, you can plot the +DI/-DI using the Wilder's DMI (ADX) indicator above, below, or behind the price plot chart. The Parameters text box controls the number of periods used to calculate the ADX, with the default being 14. The Position drop-down menu controls the positioning of the indicator.
Bear in mind that increasing the number of periods will smooth the ADX line (making it less volatile), and display more significant readings. The readings, however, will present more of a lag. For example, if charting 30 periods, readings over 40 become stronger indicators of a trend. However, the trend may have already started and could have been caught earlier less periods were used.

Summary

Wilder in his book advises that the ADX is best used in more volatile market conditions. He also advocates use of what he calls the "extreme point rule" when implementing trades. For use in the E-Mini issues the ADX provides excellent results when used with a complementary indicator such as moving averages. The ADX is also a useful tool for setting up scans for issues in the beginning stages of trends and to avoid issues mired in trading ranges.


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