Average Directional Movement Index (ADX): How this indicator can help you avoid the congestion

What is the ADX?

The average directional movement index is a momentum indicator that attempts to assess the strength of a current trend and to measure the directional movement of price.

The key principle behind the calculation was that in the event of an up trend, a current day’s high would likely be higher than that of the previous trading day.

Conversely, in the event of the down trend, a current day’s low would likely be lower than that of the previous one.

The average directional movement index is a measure of the strength of a trend, be it upward or downward.

Put it this way.

If you find an instrument with a reading over 40, this would mean a strong trend but would not identify it as biased upward or downward.

The average directional movement index can be used to identify potential changes in a market from non-trending to trending.

How is this task accomplished?

DMI—Directional Movement Indicator

Also designed by J. Welles Wilder, the Directional Movement Indicator (DMI) used to determine if the market is “trending” or “not trending.”

The indicator has three components: the +DI, the -DI, and the ADX.

It is suggested to buy when the Positive Directional Indicator (+DI) crosses above the –DI, or sell short when the +DI crosses below the –DI.

The average directional movement index is a smoothed derivative version of the directional movement indicator.

It is a measure of the strength of a trend, as opposed to direction: Higher ADX values suggest more “directional” market; Lower ADX values signal less “directional” market.

Here’s the thing.

The average directional movement index does not tell us whether the market is bullish or bearish.

The Overbought and Oversold conditions reflect the strength or weakness of the trend, rather than the market itself.

The DMI values range from 0 to 100. It is composed of two lines, the DI and the DI (positive and negative directions).

The ADX represents a moving average of the DMI.

Its value starts with 25 for a trend to have the required strength for its definition.

Instead of using the closing price for each bar as an input, DMI uses each bar’s net directional move.

Net directional movement is defined as the largest part of a period’s range that is outside of the previous bar’s range and includes separate calculations for positive movement (+DI) and negative movement (–DI).

+DI (Positive Directional Indicator).

The DI is an element of the average directional movement index that is used to measure an uptrend.

When the DI slopes upward, it indicated that the uptrend is gaining strength.

+DI crossing above the negative directional indicator (-DI) indicates the beginning of the uptrend.

-DI (Negative Directional Indicator).

The DI is another element of the average directional movement index that is used to indicate a downtrend.

When the slope of the -DI starts rising, it signals that the downtrend is gaining strength.

When it crosses above the DI, this indicates the beginning of a new downtrend.

If the +DI is greater than the –DI, the indicator suggests a bullish trend.

if –DI is greater than the +DI, then then the market is thought of as trending higher.

So what’s it all mean?

Since the market direction is defined by whether DMI is above or below the zero line, it is can be thought as another variation of stop and reverse trend-following system.

The basic rule for trading, while being short, is to note the high of the bar when the +DI crossed above the -DI, and both exit a short position and enter a long position on any subsequent bar when the price traded above the noted high.

For being long, the rule is to note the low of the day when the +DMI crossed below the -DMI, and both exit a long position and enter a short position on any subsequent day when the price traded below the noted low.

This rule set will always keep the trader in a position. These crossing are referred to as bullish / bearish crossings.

How to trade the ADX: a simple rule

Traders who use ADX follow an uncomplicated rule:

While the ADX can signal the end of the current trend, a reversal of the trend is not always the next step.

Instead, the market may enter a consolidation phase and move from left to right for a period of time.

The ADX is not useful during sideways markets.

One has to rely on other indicators for the possible direction of the next move.

The average directional movement index has become a popular tool used extensively to determine the trend with the following rules: