The ADX Indicator or The Average Directional Movement Index Indicator is used to analyze the strength of the trend of a stock or a commodity. It is part of The Directional Movement System, developed by J.Welles Wilder. It was developed in 1978. Since then it is widely used in stock trading for the technical analysis of the stock.
The Directional Movement System comprises of five indicators namely:
All these are thoroughly explained in the book, New Concepts in Technical Trading Systems (Click here to buy this book) written by J.Welles Wilder. This book gives complete instructions on calculating and interpreting each of the above indicators along with examples.
In this book, this is what Welles Wilder has written about ADX Indicator.
ADX Indicator is developed as an indicator of trend strength in a series of prices of a financial instrument. It has become a widely used indicator for technical analysts, and is provided as a standard in collections of indicators offered by various stock technical analysis software and trading platforms.
We need price data consisting of high, low, and closing prices for each time period. With this Directional Movement (+DM and -DM) is first calculated. Then Directional Indicator (+DI and -DI) is calculated.
Now Directional Movement Index (DX) is calculated. This is calculated by dividing the difference between +DI14 and -DI14 by the sum of +DI14 and -DI14, and multiplying by 100.
DX=(difference between +DI14 and -DI14 / sum of +DI14 and -DI14)X100
With this formula DX is a number which is always between 0 and 100.
The higher the DX, the more directional the movement, the lower the DX, the less directional the movement. Notice that whether the price movement is up or down, it makes no difference relative to the value of the DX.
Suppose that the price goes straight up for 14 days or more and then turns around and goes straight down for 14 days or more. The DX decreases as the price tops out and turns down, and it will increase again as the price continues down. Both the up move and down move represent good directional movement.
ADX Indicator or The Average Directional Movement Index Indicator is the 14 days average of DX. This is done to smooth out the DX
The ADX does not indicate the trend direction. It only indicate trend strength.
As the price tops out and starts down, the difference between the +DI14 and -DI14 will decrease, go to zero and then increase. That is as the price is going up, +DI14 will be a large number and -DI14 will be a small number. As the price tops out and goes down, the equilibrium point will be reached, then the -DI14 will increase and the +DI14 will decrease and therefore the difference will again increase.
In the chart above please note that we got the buy signal only after the trend is established.
A long trade is taken when +DI14 crosses above -DI14 and a short trade is taken when -DI14 crosses above +DI14. Stocks with higher ADX are selected to trade.
ADX between 0 to 25 indicate a range bound movement. Stay away from this market.
When it starts to move above 25, depending on whether +DI14 is above -DI14 or -DI14 is above +DI14, plan a long or a short trade set up.
When the ADX moves above 30 you will see strong movement.
As long as it is above 40 you will be in good trend. Most stock wont see ADX beyond 50, which indicates a very strong trend.
If it starts falling down tighten your stop loss order to exit with good profit and do not stay in the market if it falls below 40.
In the chart above please note that the ADX Indicator move up, whether the trend is bullish or bearish. The trend is determined by Directional Indicator.
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