The Average Directional (Movement) Index (ADX), also known as the Directional Movement Index (DMI) was introduced in the mid-1970s by Welles Wilder, who developed a trend-following technique that he called the Directional System. This method was elaborated and modified by a number of technical analysts.
” The Directional System is used to measure the strength of market trends, i.e. the trendiness of a market. “
When calculating the ADX, a chartist applies two more indicators: Plus (or Positive) Directional Indicator (+DI) and Minus (or Negative) Directional Indicator (-DI). It takes several steps to build an ADX:
- Determine directional movement (DM) by comparing yesterday’s and today’s price range, or the distance from the highest to the lowest levels. Directional movement is the largest part of today’s range that lies outside of yesterday’s range.
Measure the true range (TR) of the market. TR is always a positive value, the largest of the three:
the distance between today’s high and today’s low;
the distance between today’s high and yesterday’s closing price;
the distance between today’s low and yesterday’s closing price.
2. Calculate daily directional indicators: the Plus Directional Indicator (+DI) and the Minus Directional Indicator (-DI). They are used to compare various markets, expressing their directional movement as a percentage of each market’s true range. Each of the DIs is a positive figure: +DI equals zero if there is no clear uptrend within the day; -DI equals zero if there is no clear downtrend within the day.
Identify smoothed (averaged) directional lines. Smoothed +DI and –DI are created with the help of a 13-day EMA. As a result, there are two smoothed indicator lines, the one is positive and the other is negative. The relationship between positive and negative lines reflects market trends. Once you have completed these actions, you can calculate the Average Directional Movement Index. This component of the Directional System shows when a trader should follow a trend. The ADX measures the difference between two directional lines (+DI and –DI). This index is calculated as follows:
This indicator measures the strength of a trend. A rising ADX implies that a market trend is gaining strength, marking the best moment to place trend-following orders. A falling ADX means that the trend strength is weakening. In this case, a trader is recommended to track signals sent by oscillators.
” Directional analysis serves to trace changes in mass optimism and pessimism, measuring the ability of bulls and bears to push prices beyond the limits of the previous day’s range. “
If today’s high is above yesterday’s high, the market becomes more optimistic. Similarly, if today’s low is below yesterday’s low, then the market sentiment shifts to pessimism.
When analyzing directional indicators, pay attention to these signals:
If the +DI line is above the –DI line, the trend is moving upwards.
If the +DI line is below the –DI line, the trend is moving downwards.
If the two lines diverge, the directional movement of a trend increases.
The convergence of the two lines indicates a pause in the existing trend or an upcoming reversal.
Follow these trading rules if you use the Directional system method:
- Buy when the +DI rises above the –DI and sell when the -DI is higher than +DI. The best moment to buy is when both the +DI and ADX are above the –DI, with a rising ADX. This setup signals a stronger bullish trend. It is best to sell when the –DI and ADX are above the +DI, with a rising ADX.
- A falling ADX indicates that the trend strength is decreasing and further price direction is unclear. When the ADX moves lower or falls below both DI lines, we observe a trendless market. In this case, the use of directional indicators is not recommended.
” The best signal in the Directional System occurs when the ADX first falls below both DI lines and then rises. “
If that is the case, be prepared for a new bullish or bearish trend to emerge. If the ADX rises by four points, for example, from 18 to 22 from its lowest point below both DIs, this is a clear signal that a new trend is about to start. Enter long positions when the +DI is higher and place stop orders below the most recent bottom. Conversely, sell if the –DI is higher.
The rising ADX confirms the continuation of the bullish trend, indicated by the +DI line moving higher, and sends a buy signal.