Average Directional Index

Definition:

The Average Directional Index or ADX was originally developed by J. Welles Wilder who wrote about it in his book: “New Concepts in Technical Trading Systems.” This popular technical indicator helps traders determine if a trend exists and if so, how strong it is and in what direction it is heading.

The ADX indicator is most commonly run over a 14 period time frame and consists of the following three lines used in combination:

1. Positive Directional Indicator or +DI: This line represents the strength of the upwards trend.
2. Negative Directional Indicator or -DI: This line indicates the strength of the downwards trend.
3. Average Directional Index or ADX: An average involving the +DI and the –DI levels computed over the 14 period time frame.

Trading signals are generated using the ADX based on crossovers among the +DI and –DI lines and their direction. The ADX is a lagging indicator relative to the price and ranges between 0 and 100. ADX levels under 20 tend to indicate a weak trend, while levels over 40 indicate a strong trend.

Sample Chart:

Usage:

Traders often observe several things about the Average Directional Movement indicator when using it in practice. First, they will see whether +DI or –DI is on top. An uptrend is indicated by +DI being in the superior position, while a downtrend is indicated by –DI being plotted higher.

Then, traders using the ADX will observe the magnitude of any separation between –DI and +DI. The size of their deviation will indicate the strength of the trend in progress, if any.

When using the ADX to generate trading signals, perhaps the simplest method involves looking for crossover points between +DI and –DI. For example, if –DI crosses upwards above –DI, then a sell signal would be generated as the market turns downward. Alternatively, if +DI crosses above –DI, then a buy signal would be indicated as an up trend starts to take over.

Some traders add greater complexity to these simple signals by increasing the divergence criteria for a trend to exist and a position to be established. Wilder, on the other hand, suggested using “points of extremeum” that were the high for an uptrend crossover day and the low for a crossover day indicating a downtrend. Once the market price exceeded those points, the signal to trade in the direction of the indicated trend would be triggered.

Calculation Method:

The calculation method illustrated below can be varied by using different time periods or by substituting several alternative types of moving averages that might include: simple, weighted and adaptive moving averages, for the exponential moving averages.

Define:

• n= the number of time periods.
• High(n)= The high price traded during time period n.
• High(n-1)= The high price traded during the time period immediately prior to n.
• Low(n)= The low price traded during time period n.
• Low(n-1)= The low price traded during the time period immediately prior to n.
• Close(n)= The closing price of time period n.
• Close(n-1)= The closing price of the time period immediately prior to n.
• EMA(A,B)= An Exponential Moving Average of data item A over B periods.
• ADX(n)= The Average Directional Index over n periods.
• ATR= Average True Range, an EMA of the true ranges.

Calculate:

• UpMove= High(n) – High(n-1)
• DownMove = Low(n-1) – Low(n)
• +DM=UpMove if UpMove>0 and >DownMove, otherwise +DM=0
• -DM=DownMove if DownMove>0 and >UpMove, otherwise +DM=0
• +DI= 100*EMA(+DM/ATR, 14)
  This line represents the strength of the upwards trend.
• -DI= 100*EMA(-DM/ATR, 14)
  This line indicates the strength of the down trend.
• ADX(14)= 100 * EMA(ABS(+DI- -DI)/(+DI + -DI), 14)

Practice ADX Trading

Technical analysis is a demanding skill that requires practice to master. We recommend that you use a demo account to train yourself for free before applying your skills to real money trading.
Most reputale trading platforms today (for example: GFC Trader, AVA Trader, Meta Trader) feature technical indicator functions which can be applied on real-time charts. You can open a free account, download the trading software and start sharpening your technical analysis skills today!

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