Introduction: Average Directional Index (ADX), developed by Welles Wilder, is a unique indicator which is used to measure trend strength. Wilder developed this indicator for commodities; however this indicator works well in the stock market. The ADX indicator can determine trend direction and reversals in addition to measuring the strength of the prevailing trend. This indicator consists of three different lines. These lines are ADX line, +DI line and –DI line.

NLY Chart

Daily chart of NLY (given above) is showing an example of ADX indicator.

Calculation:

The default period of ADX indicator is 14, however it can be changed if needed. Here is the calculation of ADX indicator.

First, you have to calculate +DI and –DI. You need high, low and closing price data for each day to calculate +DI and –DI.

UpMove = Today’s high – Yesterday’s high

DownMove = Yesterday’s low – Today’s low

If, UpMove > DownMove and UpMove > 0, then +DM = UpMove, otherwise +DM = 0

If, Downmove > UpMove and DownMove > 0, then –DM = DownMove, otherwise –DM = 0

Now, +DI = 100 times EMA of +DM / Average True Range or ATR

-DI = 100 times EMA of –DM / ATR

ADX = 100 times EMA of the absolute value of (+DI -DI) divided by (+DI + -DI)

Interpretation: The ADX indicator is generally used to detect trend strength, trend direction and bottom of a trend. Here, we will discuss all of these signals of ADX.

Determining Trend Strength: Traders can determine the strength of a trend by using ADX line of ADX indicator. Traders imagine a line or level in ADX indicator, the value of this line is 20 (some trader use 25). If the ADX line is above this line, then the current trend is considered a strong trend. If the ADX line is below this 20 line, then the current trend is weak or in ranging condition. The ADX line is mostly used to determine trend strength rather than trend direction

Daily chart of CMG (given above) is showing strength and weakness of trend.

Determining Trend Direction: Positive Directional Index (+DI) and Negative Directional Index (-DI) of ADX indicator determine trend direction and trend reversals. Trend is bullish when +DI line is above –DI line. Inversely, trend is bearish when –DI line is above +DI line. Crossovers between +DI and –DI line detect trend reversals. It is a bullish crossover as the +DI line crosses above the –DI line. It is a bearish crossover as the –DI line crosses above the +DI line.

The ADX indicator can give you an idea about the possible top and bottom of a trend. This indication is more like overbought and oversold signals. Traders imagine an extreme value of ADX, which is the 35 line. If the +DI line moves above this line, then it is the possible top of an uptrend. Inversely, it is the possible bottom of a downtrend when the -DI line of ADX indicator crosses above the 35 line.

Note: It is not appropriate to use the ADX line alone as ADX line cannot indicate trend direction. +DI and –DI line crossover should be used with ADX line to avoid whipsaws and false signals. Using other indicators with ADX may also boost the efficiency.