24. ADX Average Directional Index

ADX Average Directional Index

The average directional movement index (A.D.X.) is a combination of two other indicators (The positive directional indicator (abbreviated +DI) and negative directional indicator (-DI) was developed in 1978 by J. Welles Wilder. 

The Average Directional Movement Index (ADX) technical analysis indicator describes when a market is trending or not trending. When combined with the DMI+ plus and DMI- minus (see: DMI) the ADX can generate buy and sell signals. 

However, the main purpose of the ADX is to determine whether a stock, future, or currency pair is trending or is in a trading range. Determining which mode a market is in is helpful because it can guide a trader to which other technical analysis indicators to use.

Calculations

The average directional movement index (A.D.X.)is a combination of two other indicators the positive directional indicator (abbreviated +DI) and negative directional indicator (-DI). The A.D.X. combines them and smooths the result with a smoothed moving average.
To calculate +DI and −DI, one needs price data consisting of high, low, and closing prices each period (typically each day). One first calculates the directional movement (+DM and −DM):

UpMove = today's high − yesterday's high

DownMove = yesterday's low − today's low

if UpMove > DownMove and UpMove > 0, then +DM = UpMove, else +DM = 0

if DownMove > UpMove and DownMove > 0, then −DM = DownMove, else −DM = 0

After selecting the number of periods (Wilder used 14 days originally), +DI and −DI are:

+DI = 100 times the smoothed moving average of (+DM) divided by average true range

−DI = 100 times the smoothed moving average of (−DM) divided by average true range

The smoothed moving average is calculated over the number of periods selected, and the average true range is a smoothed average of the true ranges. Then:

A.D.X. = 100 times the smoothed moving average of the absolute value of (+DI − −DI) divided by (+DI + −DI)

Variations of this calculation typically involve using different types of moving averages, such as an exponential moving average, a weighted moving average or an adaptive moving average.

The chart contract below shows an excellent example of the ADX in action:

ADX Shows Trend Strength

The first concept to remember is that the direction that the ADX moves doesn't depend upon the direction of the underlying stock. All the ADX shows is the trend strength.

1. Strong upward trend of stock = Increasing ADX
2. Strong downward trend = Increasing ADX

As can be referenced from the chart of the E-mini Russell 2000 Index Futures contract above, when the e-mini future was rising in a strong upward trend, the ADX indicator was rising.

When the e-mini futures contract moved into a non-directional consolidation phase, the ADX decreased.

ADX is a Great Complement to Other Technical Indicators

The ADX is so popular because determining whether a stock, commodity, or currency market is trending or not trending can help a trader avoid the pitfalls of some indicators.

Moving Averages

Moving averages and their variants are effective during trending markets; however, during consolidation periods when prices go up and down, but in no direction, moving average indicators have a tendency to give numerous false buy and sell signals that add up to trading losses. During trending markets, use moving averages, trend-lines, and other trend following technical indicators.

Oscillators

Oscillators are extremely effective in non-trending markets. Buying low and selling high is accomplished quite readily with oscillators. Unfortunately, during trending markets, oscillators perform quite poorly, often selling short during a bull market run or buying during a bear market downtrend, adding up to large losses. For periods of non-trending, use oscillators like Stochastic Fast & Slow, RSI, or Williams %R and other range-bound indicators like Bollinger Bands or Moving Average Envelopes.

The importance of the 20-level and 40-level, along with more examples of the ADX in action,

Interpreting the ADX

It is important to re-emphasize that the direction of price doesn't affect the ADX; it is the strength of the stock, futures, or currency's trend that matters.

Below, we see the contract chart , but here the e-mini future is in a downtrend, a strong downtrend. Note that the ADX is rising even though the price of the contact is falling.

Interpreting the ADX

• Below 20: Non-trending market.
• Crosses above 20: Signal that a trend might be emerging; consider initiating buy or sell short in direction of prevailing stock, future, or currency price movement.
• Between 20 & 40: If ADX is increasing between 20 and 40, then it is further confirmation of emerging trend. Buy or shortsell in the direction of the current market direction. Avoid using oscillator technical indicators and use trend following indicators like moving averages.
• Above 40: Very strong trend.
• Crosses above 50: Extremely strong trend.
• Crosses above 70: "Power Trend"; very rare occurence

In his book, New Concepts in Technical Trading Concepts, Welles Wilder, Jr., the creator of the ADX also created the DMI+ and DMI- indicators to generate buy and sell signals specifically for the ADX technical analysis indicator. In fact the ADX is derived from the DMI+ and DMI- calculations (see: DMI).

Sum  Example with ADX

Trending Stocks : ADX works on absolute value. As long as the value is above 25, it is considered as uptrend. Some of the novice trader gets confused when the value falls. Even if ADX falls to above 25 from a higher value, it is considered as trending but it signifies that the trend is weakening and time to get alerted.

Example of Trading Strategies Used With ADX Shown In Axis Bank Chart

Strong Trend: An increase in ADX value of above 25, means that trend is getting stronger and and provides better confidence to the trader.

Divergence: As mentioned earlier, divergence in ADX does not predict fall in price. As long as the value stays above 25, the trend is intact.

Change of Trend : ADX crossing below 25 signifies end of trend or movement in no trade zone.

Non-trending: ADX between 0 to 25 refers to a non trending zone.

Trade with Trailing Stop Loss: Since it indicates about the continuation trend only and not the ultimate target, it can best be traded with trailing stop loss or partial profit booking.

Directional Movement: While ADX provides information only about the strength of the trend, it is normally supplemented with Directional Index +DI and -DI. They indicates direction of the trend. Their interpretation is as follows:
1.When +DI is above -DI then trend is up trend.
2.When -DI is above +DI then trend is downwards.
3.+DI crossing over -DI signals bullish trend and vice verse.

Example of Directional Movement(+DI and -DI) Used With ADX Shown In SBIN Chart

Weakness
1.ADX is based on Moving Averages. Therefore it is slow to react or in other words it is lagging indicator.
2.ADX may not provide signals for slow moving stocks.
3.Crossover of +DI and -DI some times can happen too frequently, thereby giving many false signals.
4.As with other indicators, use ADX when other indicators of your reliance are supporting them.

Example of Too Many Crossover of +DI and -DI as Shown In Boeing Co Chart

Example of Too Many Crossover of +DI and -DI as Shown Axis Bank Chart