ADX (Average directional index)
The average directional movement index (ADX) was developed in 1978 by J. Welles Wilder as an indicator of trend strength in a series of financial instrument prices. ADX has become a widely used indicator for technical analysts and is provided as a standard in collections of indicators offered by various trading platforms.
The simplest trading method based on the system of directional movement implies a 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 as a market entry level. Thus, after a buy signal (+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.
Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below 20;
When the ADX turns down from high values, then the trend may be ending. You may want to do additional research to determine if closing open positions is appropriate for you;
If the ADX is declining, it could be an indication that the market is becoming less directional, and the current trend is weakening. You may want to avoid trading trend systems as the trend changes;
If after staying low for a lengthy time, the ADX rises by 4 or 5 units, (for example, from 15 to 20), it may be giving a signal to trade the current trend;
If the ADX is rising then the market is showing a strengthening trend. The value of the ADX is proportional to the slope of the trend. The slope of the ADX line is proportional to the acceleration of the price movement (changing trend slope). If the trend is a constant slope then the ADX value tends to flatten out.
It is interesting that ADX, being a trend indicator, is plotted not on the chart, but in a separate window. Because of this, some traders consider it an oscillator, but formally it is a trend detection indicator.
Calculation
ADX = SUM ((+DI - (-DI)) / (+DI + (-DI)), N) / N
Where:
N — the number of periods used in the calculation;
SUM (..., N) — sum for N periods;
+DI — value of the positive price movement indicator (positive directional index);
-DI — value of the negative price movement indicator (negative directional index).
Main parameters
Period – Moving average period for calculation, 14 by default.
This technical indicator looks as follows on the chart:
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