J. Welles Wilder developed the Average Directional Index (ADX) to evaluate the strength of a current trend, be it up or down. It’s important to determine whether the market is trending or trading (moving sideways), because certain indicators givemore useful results depending on the market doing one or the other.
The ADX is an oscillator that fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend and high readings, above 40, indicate a strong trend. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend. A reading above 40 can indicate a strong downtrend as well as a strong uptrend.
ADX can also be used to identify potential changes in a market from trending to non-trending. When ADX begins to strengthen from below 20 and moves above 20, it is a sign that the trading range is ending and a trend is developing.
When ADX begins to weaken from above 40 and moves below 40, it is a sign that the current trend is losing strength and a trading range could develop.
The ADX is derived from two other indicators, also developed by Wilder, called the Positive Directional Indicator (sometimes written +DI) and the Negative Directional Indicator (-DI).
When the ADX Indicator is selected, SharpCharts plots the Positive Directional Indicator (+DI), Negative Directional Indicator (-DI) and Average Directional Index (ADX). With the Red, White and Green color scheme on SharpCharts, ADX is the thick black line with less fluctuation, +DI is green and -DI is red. +DI measures the force of the up moves and -DI measures the force of the down moves over a set period. The default setting is 14 periods, but users are encouraged to modify these settings according to their personal preferences.
In its most basic form, buy and sell signals can be generated by +DI/-DI crosses. A buy signal occurs when +DI moves above -DI and a sell signal when -DI moves above the +DI. Be careful, though; when a security is in a trading range, this system may produce many whipsaws. As with most technical indicators, +DI/-DI crosses should be used in conjunction with other aspects of technical analysis.
The ADX combines +DI with -DI, and then smooths the data with a moving average to provide a measurement of trend strength. Because it uses both +DI and -DI, ADX does not offer any indication of trend direction, just strength. Generally, readings above 40 indicate a strong trend and readings below 20 a weak trend. To catch a trend in its early stages, you might look for stocks with ADX that advances above 20. Conversely, an ADX decline from above 40 might signal that the current trend is weakening and a trading range is developing.
With SharpCharts, you can plot the +DI/-DI using the Wilder’s DMI (ADX) indicator above, below, or behind the price plot chart. The Parameters text box controls the number of periods used to calculate the ADX, with the default being 14. The Position drop-down menu controls the positioning of the indicator.
Bear in mind that increasing the number of periods will smooth the ADX line (making it less volatile), and display more significant readings. The readings, however, will present more of a lag. For example, if charting 30 periods, readings over 40 become stronger indicators of a trend. However, the trend may have already started and could have been caught earlier less periods were used.
More on ADX can be found in Wilder’s book, New Concepts In Technical Trading Systems, written in 1978. Wilder’s indicators remain some of the best and most popular indicators today.