The Average Directional Movement Index, or ADX, is a powerful tool for traders looking to identify price trends. Developed by Welles Wilder and detailed in his book, "New Concepts in Technical Trading Systems," the ADX is essential for anyone serious about their trading strategy.
The basic premise of using the ADX revolves around comparing two directional indicators: the 14-period +DI and the 14-period -DI. To utilize this system, you can either overlay the indicators on your charts or subtract -DI from +DI. As a rule of thumb, Wilder suggests you should buy when +DI is above -DI and sell when +DI dips below -DI.
To enhance these straightforward trading rules, Wilder introduced the concept of the "point of extremum." This point helps filter out false signals and reduces the number of trades. The extremum point occurs when +DI and -DI cross each other: if +DI rises above -DI, that point marks the day’s maximum price at the crossover; conversely, if +DI falls below -DI, it indicates the day’s minimum price.
Once you identify the extremum point, it becomes your market entry level. So, after receiving a buy signal (when +DI is higher than -DI), you should wait until the price surpasses the extremum point before entering a trade. If the price doesn't break above that level, it’s wise to hold onto your short position.
Calculation
ADX = SUM ((+DI - (-DI)) / (+DI + (-DI)), N) / N
Where:
N — the number of periods used in the calculation.
Technical Indicator Description
For a deeper dive into the ADX, check out the full description available in the Technical Analysis: Average Directional Movement Index.
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