Incorporating the Average Directional Index (ADX)
This is a trend following indicator developed by Welles Wilder, the author of the book "New Concepts in Technical Trading". In this text he explains, in detail, this particularly difficult to understand mathematical indicator, fortunately it's relatively easy to use.
The Average Directional Index (ADX) when coupled with the positive (+DMI) and the negative (-DMI) directional indicators, provide a complete and accurate trading system. It's not possible to go into the full details of how to arrive at the indicators in this limited space, but it is possible to have a discussion about the concept.
First we need to arrive at a directional movement indicator, + or - DM or no change. It is defined simply as the largest part of the current range outside the previous range. If it's higher then it's positive +DM, if it's lower, then it is negative or -DM. DM is 0 if the range is wholly within or the same as the previous range.
A rather complicated set of calculations is then embarked on, which goes to average the +DMI, -DMI and the true range. The actual result will be a number that will always lie between 0 and 100 and therefore is the absolute value of direction, up or down. The plus and minus refer to direction, movement up and movement down respectively.
The DMI indicators are displayed as two distinct lines, usually below the bar chart. In the example below the -DMI is the red line and the +DMI is the blue line.
Average Directional Index
The next step is to compute the directional index DI by bringing the +DMI and -DMI to a percentage with respect to the true range. It's an expression of the average true range for both the up and the down trading intervals. This will yield two separate indicators once again the +DI and the -DI.
The DX is computed by taking the difference between these two indicators and dividing by the sum and then bringing them to a percentage by multiplying by 100, which will place the indicator somewhere between 1 and 50.
To smooth out some wild swings during volatile movements in the market Wilder then applies his accumulated averaging technique, which is an interesting calculation technique all on its own, to arrive at the ADX.
The ADX is displayed below the bar chart usually. It can be displayed separately or in conjunction with the DMI indicators.
How to use the indicators
Now we have a complete trading system at our disposal and it's very easy to use.
The first and most basic signal is to buy the market when the +DMI crosses above the -DMI and to sell the market when the -DMI crosses above the +DMI.
There is a caveat to the cross over signal known as the extreme point rule. Wilder suggested implementing this filter to avoid the problem of being "whip-sawed". It states that one should not instigate a long position until price has taken out the high posted on the day or bar that the +DMI crossed above the -DMI.
Conversely one should wait to establish a short position until the low of the bar that was made when the -DMI crossed above the +DMI is taken out.
The signal generated from the DMI cross, works great in a trending market and poorly in a sideways market. Wilder recommended only using the system when the market was trending. That then gave rise to the Average Directional Index (ADX) and the turning point concept. The ADX must be above both the +DMI and the -DMI, if it then turns, especially from a high value, it is indicating a similar retracement in price against the underlying trend. Remember the ADX is a trend indicator and doesn't reflect the direction of the trend, just whether the market is trending or not.
In the example below, the first vertical line on the chart marks the first cross, which has generated a sell signal. That sell signal was supported by the ADX, because it was above the other indicators and had turned to indicate a change in trend. This change in trend turned out to be a consolidation in the market as it moved into a non trend or sideways mode. The next signal was generated when the +DMI crossed above the -DMI issuing a buy signalled. The fact that the ADX was still above theses indicators in value, still above 20 and therefore trending, supported the buy signal, even after allowing for the extreme point rule, which needed to be employed.
The DMI indicator has maintained a long position and captured a large part of the resultant bull market. The ADX is also moving higher, indicating continuation of the current trend.