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. Although Wilder designed his Directional Movement System with commodities and daily prices in mind, these indicators can also be applied to stocks.
Positive and negative directional movement form the backbone of the Directional Movement System. Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between their respective highs.
The Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI) are derived from smoothed averages of these differences and measure trend direction over time. These two indicators are often collectively referred to as the Directional Movement Indicator (DMI).
The Average Directional Index (ADX) is in turn derived from the smoothed averages of the difference between +DI and -DI; it measures the strength of the trend (regardless of direction) over time.
Using these three indicators together, chartists can determine both the direction and strength of the trend.
Wilder features the Directional Movement indicators in his 1978 book, New Concepts in Technical Trading Systems. This book also includes details on Average True Range (ATR), the Parabolic SAR system and RSI. Despite being developed before the computer age, Wilder’s indicators are incredibly detailed in their calculation and have stood the test of time.
- Designed by Welles Wilder for commodity daily charts, the ADX is now used in several markets by technical traders to judge the strength of a trend.
- The ADX makes use of a positive (+DI) and negative (-DI) directional indicator in addition to the trendline.
- The trend has strength when ADX is above 25; the trend is weak or the price is trendless when ADX is below 20, according to Wilder.
- Non-trending doesn’t mean the price isn’t moving. It may not be, but the price could also be making a trend change or is too volatile for a clear direction to be present.
How does this Indicator work?
The ADX indicator of trend strength is as follows:
- When the ADX is greater than 25, the trend strength is sufficient for trend-following strategies.
- When the ADX is less than 25, traders should avoid using trend trading strategies because the market is in an accumulation or distribution phase.
- ADX measures the strength of an uptrend when it is greater than 25, and the +DMI (positive directional movement index) is greater than the -DMI (negative directional movement index).
- ADX measures the strength of a downtrend when it is greater than 25, and the +DMI is greater than the -DMI.
- ADX values greater than 50 indicate a very strong trend.
The Directional Movement System indicator calculations are complex, interpretation is straightforward, and successful implementation takes practice. +DI and -DI crossovers are quite frequent and chartists need to filter these signals with complementary analysis. Setting an ADX requirement will reduce signals, but this uber-smoothed indicator tends to filter as many good signals as bad. In other words, chartists might consider moving ADX to the back burner and focusing on the Directional Movement Indicators (+DI and -DI) to generate signals. These crossover signals will be similar to those generated using momentum oscillators. Therefore, chartists need to look elsewhere for confirmation help. Volume-based indicators, basic trend analysis and chart patterns can help distinguish strong crossover signals from weak crossover signals. For example, chartists can focus on +DI buy signals when the bigger trend is up and -DI sell signals when the bigger trend is down.
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