Click here to Email this article
The ADX will not only help you learn to trade the market successfully but also will aid you to trade this current market very well. That said; it is known in technical analysis that basing your investment decisions on only one indicator is NEVER recommended. It is best to use it with one or two additional indicators of different types in order to confirm signals and prevent false ones.
Our topic today is the most challenging well-known technical indicator out there! :) Take heart! If you will be able to understand this one and I am sure you will, almost everything else will be like a walk in the park. Seriously. This one is not visually intuitive and needs some effort to work your hands around it.
J. Welles Wilder developed the directional Movement Index in 1978 and published it in his book New Concepts in Technical Trading Systems. It is an indicator to determine if a security or a market is trending, evaluate the strength of that trend, and define periods of ranging (sideways trading). It works on all time frames and can be applied to any underlying vehicle (Stocks, ETF, commodities, currencies, etc).
It involves 5 indicators: Directional Index (DX), the plus (positive) Directional Indicator (+DI), the minus (negative) Directional Indicator (-DI), the Average Directional Movement (ADX) and the Average Directional Movement Rating (ADXR).*
The Directional Index (DX) is a raw version of the Average Directional Index (ADX), which is calculated as an exponential moving average** from the DX. Both used in the same way. To calculate the Directional Index (DX), a range is determined by comparing today's high and low with yesterdays close. If the largest part of today's range is above yesterday's range, the directional movement is plus. If the largest part of today's range is below yesterday's range, the directional movement is minus. If today's range is within yesterday's range, then directional movement is defined as zero. ***
Monthly Weekly Daily
For this article we will use the most common index that appears in charts’ software, which is the Average Directional Movement Index (ADX) combined with positive and negative directional indexes, +DI and -DI. It is known in stockcharts.com (charts above) as Wilder's DMI (ADX)
Notice that below I'll use numbers in different colors next to topics. I will later post the annotated charts to highlight these numbers on the charts above. Take sometime to study them and email your annotated ones to me if you like or wait until I post mine to see how you correctly were able to see these points of this article worked on the charts. Okay, let us take one at a time.
.............
~ (+DI) measures the force of positive (upward) true range movement over a set period. [1] (-DI) measures the force of the negative (downward) true range movement over a set period. [2]
Do not let the plus or minus sign designation misleads you. They only indicate upward or downward movement, not values. The directional movement value is always a positive number of absolute value, regardless of upward or downward movement.
The +DI generally moves in sync with price, which means that the +DI rises when price rises, and it falls when price falls. -DI behaves in opposite manner and moves counter-directional to price. It rises when price falls, and it falls when price rises. So generally when +DI is dominant and rising, price direction is up and when -DI is dominant and rising, price direction is down.
When the +DI is above the -DI, a bullish market is implied. As the +DI cross, giving the -DI top billing, a bearish market is implied.
(1) Generally, an initial buy signal is given when the (+DI) line crosses over the (-DI) line. A sell signal is generated when the (+DI) line crosses below the (-DI) line. It signals a potential of change in direction. +DI and -DI lines intersection precedes a new trend or strengthens the prevailing one. False crossovers (whipsaws) will occur if you use this step alone.
(2) In effort to keep you from getting whipsawed when a crossover occurs especially if your time-frame is short, use the extreme price known as "The extreme point rule" as the reverse point. "The extreme point” is the point when +DI and -DI cross each other. If +DI rises 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. You maintain the reverse point (high or low) as your market entry or exit price even if the +DI and the -DI remain crossed for several trading intervals. Thus, for example after the signal to buy (+DI is higher than -DI) one must wait till the price has exceeded the extreme point, and only then buy. However, if the price fails to exceed the level of the extreme point, one should retain the short position.
(3) The strength of price movement measured by the plus or minus DI is the key. For prices to continue in a strong trend even when we get an opposite crossing signal to the current trend depends on continued strength in the dominant DI. The higher the DI (+ or -) value, the stronger the trend will continue. Generally, we use DI values over 25 to indicate that the price is directionally strong and DI values under 25 to indicate that the price is directionally weak.
(4) Generally, when the bulls are stronger than the bears, the +DI reading will be above 25 and the -DI reading will be below 25 indicating that the dominant trend is up. When the bears are stronger than the bulls, the -DI reading will be above 25 and the +DI reading will be below 25 indicating that the dominant trend is down. A strong uptrend will show a series of rising +DI readings that remain above the -DI for extended periods of time. The opposite is true for strong downtrends where you will see a series of rising –DI readings that remain above +DI.
(5) When both DI lines are below 25 and moving sideways, there is no dominant force and a clear trend will be absent from the market. A trend trader should avoid such market. However, a good setup begins after long periods where the DI lines cross back and forth under the 25. A low risk trade setup will occur after DI moves above 25.
(6) To trade in the direction of the trend or a trend breakout, watch for a new higher price confirmed by a new high reading on +DI, which supports the continuation of an uptrend. Conversely, a new lower price combined with a new high on the -DI supports the continuation of a downtrend
(7) Divergence, on the other hand is when the DI and price disagree with one another. Prices will make a new high, but the +DI will make a lower high or prices will make a new low, but the –DI also will make a new low, which should not happen. Divergence is generally a first warning sign that strength is weakening, which precedes a retracement or reversal of the current trend.
(8) Watch for periods when the DI lines move away from one another indicating volatility increases. The farther the lines separate, the stronger the volatility. At one point Contractions will occur when the lines move toward one another indicating that volatility is decreasing. Contractions precede retracement, consolidations or reversals of the current trend.
.................
As you read from above, the (+DI) goes in the direction of the price movement and (-DI) goes in the opposite direction. (ADX) is a combination of both. It represents the absolute difference between +/-DI lines, so the more divergence between +/-DI lines, the greater the value of ADX.
Now, listen up carefully! The ADX line shows the strength of the move (up or down). It does not indicate whether a trend is Bullish or Bearish and can’t recognize an up or downtrend.
ADX is not a directional indicator. An upward moving ADX does not specify market direction – only market trend intensity. For example, a reading above 40 can indicate a strong downtrend as well as a strong uptrend. Again, a rising ADX shows the beginning of a trend or an increase in the trend intensity, but not the trend direction. Similarly, a falling ADX shows the end of a trend or a decrease in trend intensity, but not the trend direction itself. Very important to know!
(1) The ADX is best used as a filter along with other indicators to create a more concrete trading methodology. It measures the strength of market trends on a 0 -100 scale; the higher the ADX value the stronger the trend.
(2) Generally, the market is considered to be trending when the ADX line is above 30, and ranging when the ADX line is below 30.
(3) Values above 40 indicate very strong trending while values below 20 indicate non-trending or ranging (consolidating) market conditions.
(4) When ADX begins to strengthen from below 20 and moves above 20, it is an early sign that a trend is emerging. It signals a new trend is developing and when it rises steadily, it signals the new trend is becoming stronger. Generally, when ADX reaches very low levels, chances for a reversal are great and when it forms a local low, it signals the market is overbought or oversold depend on the current trend. Subsequently, a turn-up higher (without reaching the 20 line) is generally a retracement or consolidation signal (not a reversal signal). Look for a confirmation and trade accordingly.
(5) Conversely, a declining ADX begins to weaken and start turning down from above 40 can be taken as a deterioration sign of the current trend. When it moves below 40, it is a sign that the current trend is losing strength and a trading range could develop. Generally, when ADX reaches very high levels, chances for a reversal are great and when it forms a local high, it signals the market is overbought or oversold depend on the current trend. Subsequently, a turn-down lower (without reaching the 40 line) is generally a retracement or consolidation signal (not a reversal signal). Look for a confirmation and trade accordingly.(6) ADX can identify potential changes in a market from trending to non-trending. When the ADX turns lower, the market often reverses the current trend. The ADX there serves as a warning but not a signal for a market about to change direction.
(7) The most significant use of the ADX is “the turning point concept”. The ADX must be above at least one DI lines. The main exception to this rule is a strong bull market during a blow-off stage. The ADX turns lower only to turn higher a few days later. According to Wilder, you should stop using any trend following system when the ADX is below both DI lines. The market is in a choppy sideways range with no easily identifiable trend, which can produce whipsaws. The good news is that the longer that ADX has remained below both +DI and -DI the stronger the subsequent trend is likely to be.
(8) Also, trend following systems preferably should be used when the ADX is above 25. Generally, the use of trend following systems is not recommended when the ADX drops below 20. What you should do is to wait until first ADX rises 4 steps off its low (e.g. ADX rises to 17 from a low of 13). A “non-trending” system should be used for confirmation, i.e., oscillators, such as MACD or Stochastics.
(9) Although an ADX that is above both +DI and -DI is a strong signal for strong trend, it is also should be taken as warning that a retracement or reversal is on the horizon. It signals that the market is becoming overheated. Hot! HOT! HOT! Take profits when ADX turns downwards from above +DI and -DI. However, REMEMBER: Get confirmation! I can’t stress this enough - when it comes to trading “with the trend” – especially while trading Currencies; the ADX is often above the DIs for an extended period of time. To interpret a move in which the ADX is above the DIs as an exit signal is generally to exit the market – TOO EARLY.
(10) The ADX is less helpful during sideways markets. During extended consolidation periods the ADX line will slip toward 10. When ADX approaches 10, a major move is usually about to take place. But the ADX line doesn't tell you which direction it will go. You have to rely on other indicators for the probable direction of the next move.
(11) When the ADX drops below 10, the current trend is virtually dead. Be ready for the beginning of a new trend – bullish or bearish. So,
if you’ve been long, and the ADX drops below 10, it’s time to secure
your profits. However, after a period of consolidation, a “new” trend
may resume in the previous direction. Again, the ADX doesn’t distinguish the direction. Use other indicators to make this decision.
(12) Interestingly, when ADX drops below 18, it often leads to a sideways or horizontal trading pattern, and the moving averages start to cluster around the price of the security. This signifies basing action within a trading range from which it is possible to draw support and resistance lines. Classic technical analysis tells us the longer the price action moves horizontal, the more likely the chart pattern will be a reversal pattern rather than a continuation pattern. When ADX moves down that low, you are in a breakout mode, and once the price breaks out, you could be setting a new trend. So draw your trendline and look for some type of breakout method, which can give you highly profitable trades.
(13) As I explained in number (8) blue, when DI lines diverge then the ADX value increases and the trend becomes stronger, and vice versa. After the DIs cross and their difference increases beginning to “pull away” from each other; better yet, the gap widens, while subsequently, the ADX continues to rise – trending market strength is implied.
(14) 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. The default setting is 14 periods. Also, it could be useful to use ADX14 and 7 together, as the ADX 7 is faster and can signal trend change. In this case, the ADX 14 can work as a filter to the ADX7
~ The Average Directional Movement Index Rating (ADXR) [Not shown in charts] quantifies momentum change in the ADX. It is calculated by adding the current ADX value and an ADX value n periods back, then dividing that sum by two. It is slightly less responsive than the ADX but is able to compensate for the variance of excessive tops and bottoms. Whenever you find it in your charting software, give it a look. The interpretation of ADXR is the same as that for ADX.
References:
* Directional Movement (DM) and the Directional Movement Index (DMI) are variant names to the same indicators we discussed above. DM is a family of indicators that Wilder created to help determine if a security is trending. The DM family of indicators has also been called the Directional Movement Index (DMI). This confuses the family of indicators with the single indicator called the Directional Movement Indicator (sometimes confusingly abbreviated DX).
The indicators and their abbreviations are- Plus Directional Indicator or Positive Directional Indicator [+DI or DI(plus)]
- Minus Directional Indicator or Negative Directional Indicator [-DI or DI(minus)]
- Directional Movement Indicator (DX)
- Average Directional Movement Indicator (ADX)
- Average Directional Movement Index Rating (ADXR)
*** More about calculation - Click here and here!
Great article GV, well done.
Posted by: dandarby | Feb 19, 2010 at 09:06 AM