Average Directional Movement Index Technical Indicator (ADX) assists to conclude if there is a price trend change. It was developed and described in detail by Welles Wilder in his book "New concepts in technical trading systems".
The simplest trading method based on the system of directional movement implies a comparison of two direction indicators: the 14-period +DI one and the 14-period -DI. To do this, one either puts the charts of indicators one on top of the other, or +DI is subtracted from -DI. W. Wilder recommends buying when +DI is higher than -DI and selling when +DI sinks lower than -DI.
- Designed by Welles Wilder for commodity daily charts, but can be used in other markets or other timeframes.
- The price is moving up when +DI is above -DI and the price is moving down when -DI is above +DI.
- Crosses between +DI and -DI are potential trading signals as bears or bulls gain the upper hand.
- The trend has strength when ADX is above 25. The trend is weak or the price is trendless when ADX is below 20, according to Wilder.
- Non-trending doesn't mean the price isn't moving. It may not be, but the price could also be making a trend change or is too volatile for a clear direction to be present.
To these simple commercial rules, Wells Wilder added "a rule of points of extremum". It is used to eliminate false signals and decrease the number of deals. According to the principle of points of extremum, the "point of extremum" is the point when +DI and -DI cross each other. If +DI raises higher than -DI, this point will be the maximum price of the day when they cross. If +DI is lower than -DI, this point will be the minimum price of the day they cross.
The point of extremum is used then as the market entry-level. Thus, after the signal to buy (+DI is higher than -DI) one must wait till the price has exceeded the point of extremum, and only then buy. However, if the price fails to exceed the level of the point of extremum, one should retain the short position.
Limitations of Using the Average Directional Index (ADX)
Crossovers can occur frequently. Sometimes too frequently, resulting in confusion and potentially lost money on trades that quickly go the other way. These are called false signals. This is more common when ADX values are below 25. That said, sometimes the ADX reaches above 25, but is only there temporarily and then reverses along with the price.
ADX = SUM[(+DI-(-DI))/(+DI+(-DI)), N]/N
N — the number of periods used in the calculation.
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