Being traders our primary zest is to capture the trend
Trading in the direction of a strong trend reduces risk and increases profit potential. The average directional index (ADX) is used to determine when the price is trending strongly. In many cases, it is the ultimate trend indicator. After all, the trend may be your friend, but it tells us when does our friend arrive.
Key take aways
Introduction of ADX
Quantifying trend strength
Strategic use of ADX
J. Welles Wilder Jr. (June 11, 1935 – April 18, 2021) was an American mechanical engineer, turned real estate developer. He is best known, however, for his work in technical analysis. Wilder is the father of several technical indicators that are now considered to be the core tenets of technical analysis software. These include the Average True Range, the Relative Strength Index (RSI), the Average Directional Index, and the Parabolic SAR. Today we will look at one of the strongest tools developed by Welles.
Introduction to ADX :
ADX is used to quantify the trend strength. ADX calculations are based on moving average and price expansion over the range period. The ADX is derived from two accompanying indicators, known as the Positive Directional Indicator (+D) and the Negative Directional Indicator (-D). Therefore an ADX indicator has three lines on the chart: +D,-D, and the ADX line.
Positive directional movement occurs when the high for a day exceeds the high of the previous day. The amount of positive directional movement (+DM) is the day’s high minus the previous day’s high. If the low for the day is less than the previous day’s low then the negative directional movement (DM) occurs. The value of the negative directional movement (-DM) is the difference between the two lows. Days on which the range is completely within the previous day’s range are ignored, and if on someday higher high and lower low is formed together, the greater difference wins. In other words, only +DM or -DM may be recorded for a particular day.
A moving average is calculated for both +DM and –DM, usually over 14 days, and in addition a 14-day.
ATR is calculated. Two indicators are calculated using this data. The positive Directional Movement Indicator (DMI+) is the ratio between the smoothed +DM and the TR. this gives the percentage of the true range that was above equilibrium for those 14 days. The second indicator is the negative Directional Movement Indicator (DMI-), which is calculated as the ratio between the smoothed –DM and the TR. The ADX is the smoothed value of DX. When the ADX is rising the market is increasingly trending in either direction. If the +DMI is higher than the –DMI. The increasing trending is on the upside and vice-versa. The high value for the ADX represents a strong trend.