The Average Directional Index (ADX)

As noted throughout this guide, the trend is your friend. The fundamental question is whether a security is trending or not. The Average Directional Index (ADX), Minus Directional Indicator (-DI), and Plus Directional Indicator (+DI) represent the Directional Movement System (DMS), created by Welles Wilder.

The key feature of the DMS is that it first identifies whether the market is trending before providing signals for trading the trend.

Directional Movement and Calculation Basis

The foundation of the system is Directional Movement (DM), which is determined by comparing the difference between today's low/high and yesterday's low/high.

• Plus Directional Movement (+DM): Measured when the price moves upwards; the difference between the current high and the previous high.
• Minus Directional Movement (-DM): Measured when the price moves downwards; the difference between the current low and the previous low.
• Tie Rule: If the daily range moves both above and below the previous day's range, only the direction with the greater movement is measured as directional movement.
• No Movement: When the trading range is within the trading range of the previous day, there is no directional movement.

Deriving the Indicators

The formula for the average directional system is based on calculating and smoothing these movements over time:

1. The Directional Indicator (DI) is calculated by dividing the Directional Movement (DM) by the True Range.
2. Wilder recommended using 14 periods to calculate the directional indicator, as one day of directional movement does not make a trend.
3. These calculations result in the Directional Movement Index (DX), which measures the difference between the two DIs.
4. The Average Directional Movement Index (ADX) is created by smoothing the DX action, typically by taking a 14-day average, making it indicative of price movements to both high and low extremes.

Interpreting the ADX (Trend Strength)

The ADX determines if a security is trending. The ADX level reflects the degree of directional movement, not the direction itself.

• Strong Trend Present: ADX is above 25.
• No Trend Present: ADX is below 20.
• Gray Zone: Between 20 and 25. Traders can use a lower level than 25 to increase sensitivity.

Interpreting +DI and -DI (Trend Direction and Signals)

Since the ADX does not show the trend direction, the +DI and -DI are used to determine direction and provide entry/exit signals.

Directional Movement Trading Signals

These signals should only be considered when the ADX confirms a strong trend (ADX > 25).

• Bullish Signal: Given when the +DI crosses above the -DI.
• Bearish Signal: Given when the +DI crosses below the -DI.

Summary of Directional Movement System Trading Rules

The ADX, +DI, and -DI create the average directional movement system and should be interpreted together.

• Trading Condition: Trade only trend-following systems when the ADX rating is above 25.
• Signal Validity: Crossovers of the DIs should only be acted upon if ADX is above 25 (e.g., a bullish signal confirmed by ADX > 25 is valid).
• Ideal Entry Point: The best trend-following signals are given when the ADX is at a low number and then moves above 25, indicating a new trend initiation.
• Trend Maturity Warning: If the ADX is above both DIs and is at an extreme reading, this means the trend has been in force for some time. This high reading is a form of overbought or oversold where new trades are usually not profitable.
• Correction Warning: When ADX is above both DIs and is at an extreme reading, it reflects a trend that is overbought or oversold and could act as a warning towards a correction.
• Avoidance Zone: When the ADX is below the 20–25 area (or below both DIs), avoid trend-following systems because little or no directional movement is indicated.

Use the crossovers of the +DI and -DI as signals for entering and exiting the market, but always remember that the ADX level reflects the degree of directional movement, not the direction itself.