by Ken Calhoun (Daytrading University)

Wilder's Directional Movement (ADX/DMI) indicator provides a combined volatility and trend signal indicator that helps identify breakout trends and trend exhaustions. An eSignal Basic Studies charting tool, it can be used in combination with other indicators, most notably volume changes, to gauge the relative strength of breakout moves as they are occurring.

The strongest signal of the ADX/DMI indicator is found when combined with a corresponding increase in volume bars as the ADX approaches and gets above 40.

General Overview of the Directional Movement (ADX/DMI) Tool

The ADX-DMI combines three indicators that describe the relative strength of trends, as well as provide exit signals for exhausted patterns. Like stochastics, it is used in both entry and crossover exit trading strategies. The three components of the ADX/DMI include:

1.

The red ADX line, which indicates the trend of the market. ADX assumes trading significance once it gets over 40.
2. The +DMI measures the strength of upside pressure.
3. The -DMI measures the strength of downward pressure.

Note that the Step Parameter may also be varied; the eSignal default of 14 is preferred. You may experiment with this value for curve-fitting purposes, much like the MA Step Parameter.

A basic +DMI/-DMI buy signal occurs when the (green) +DMI line crosses up over the (blue) -DMI line.

A basic +DMI/-DMI sell signal occurs when the (blue) -DMI line crosses down over the (green) +DMI line.

In addition, the ADX is used to measure the relative strength of the current trend, known as the directional change. When the ADX is rising over 40, the issue is in a strong trend; when it is in the 10 - 30 range, the trend is weak.

Combining this understanding of the ADX/DMI indicators with an understanding of volume bar increases forms the basis of an effective breakout trading strategy. Other factors that add strength to entries include monitoring the relative strength of the sector being traded and trading only when the composite index is outside of the previous day's trading range at the time of entry, on a new two-day high/low breakout.

Adding ADX/DMI Indicators to Your Charts

 
  For any standard chart, go to the Analytics menu (Chart Options/Properties/Analytics) and double click on "Directional Movement (ADX/DMI)" from the Analytics Set-Up menu.
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  Adjust settings as needed (line colors, step parameter). When set up correctly, the ADX/DMI lines appear in an area underneath the volume bars.
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A. Find a stock that has the (red) ADX line between 30 and 40 and for which the +DMI line has recently crossed to the upside over the -DMI line.
B. Check that the average size of the most recent 5 volume bars (e.g., 15-minute volume bars for swing trading, 1-minute volume bars for day trades) are at least 30% greater in size than the preceding volume bars. (Example: If volume bars 7 - 8 periods ago were 100K, it is preferred that you see 130K+ size volume bars at time of entry.)
C. Confirm that the ADX line is making its first move over the 40 value and is not in the process of pulling back or retesting the 40 on a subsequent move after an earlier breakout.
A. Buy the first higher candle/bar that's breaking out as the ADX gets over the 40 value on increasing volume.
B. Set an initial stop at the low end of the price that the issue was trading at when the ADX broke over the 40.
C. As the position moves in your favor, trail a protective stop at the low end of the prior bar/candle.
D. ADX-based stop (breakout entries): For breakout wins, trail a stop at the point at which the ADX line loses 5 points (Example: If the position was initiated when the ADX was at 42, and it subsequently trended in your favor to 63 before starting to flatten out, trail a stop for the issue being trading at the point at which the ADX drops back to 58.)

ADX-based stop (trending exits): If in an open position in a slow-trending stock and the price action starts to flatten out, exit the position immediately if the ADX starts to lose 40 because this helps confirm the loss of the trend.
E. Volume-based stop: Confirmation for all exits occurs if the most recent volume bars start to lose 30% or more of their value as the issue continues to trade.

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A. A. Identify an issue that is taking out new multi-day low (2-day low for day trades, 5-day low for swing trades) and for which the ADX line is between 30 and 40.
B. Check that the (blue) -DMI line has recently crossed to the upside over the (green) +DMI line.
C. Confirm that volume bar size is increasing to at least 30% greater than the immediate past volume bar size.
A. Sell the position short once the ADX gets over 40, and the stock is taking out a new low on increasing volume.
B. Trail an initial protective cover stop at the previous day's low.
C. As the position moves in your favor, trail a protective stop at the high end of the prior bar/candle.
D. Use the same ADX and volume-based trailing stop strategies as described in the buy strategy because the ADX/DMI and volume indicators are identical.
Combining ADX/DMI with volume bar increases helps to identify both the emergence of a new breakout entry and the flattening of a trend, once the ADX drops to under 40 and volume starts to decline. Using these technical indicators together as a system can help filter out false breakouts and ensure that breakout entries are the strongest at the time of entry..