Introduction
J. Welles Wilder developed the Average
Directional Index (ADX) to evaluate the strength of a current trend, be it up
or down. It's important to determine whether the market is trending or trading
(moving sideways), because certain indicators give more useful results
depending on the market doing one or the other.
The ADX is an oscillator that fluctuates between
0 and 100. Even though the scale is from 0 to 100, readings above 60 are
relatively rare. Low readings, below 20, indicate a weak trend and high
readings, above 40, indicate a strong trend. The indicator does not grade the
trend as bullish or bearish, but merely assesses the strength of the current
trend. A reading above 40 can indicate a strong downtrend as well as a strong
uptrend.
ADX can also be used to identify potential
changes in a market from trending to non-trending. When ADX begins to
strengthen from below 20 and moves above 20, it is a sign that the trading
range is ending and a trend is developing.
When ADX begins to weaken from above 40 and moves
below 40, it is a sign that the current trend is losing strength and a trading
range could develop.
Positive/Negative
Directional Indicators
The ADX is derived from
two other indicators, also developed by Wilder, called the Positive Directional
Indicator (sometimes written +DI) and the Negative Directional Indicator (-DI).
When the ADX Indicator
is selected, SharpCharts plots the Positive Directional Indicator (+DI),
Negative Directional Indicator (-DI) and Average Directional Index (ADX). With
the Red, White and Green color scheme on SharpCharts, ADX is the thick black
line with less fluctuation, +DI is green and -DI is red. +DI measures the force
of the up moves and -DI measures the force of the down moves over a set period.
The default setting is 14 periods, but users are encouraged to modify these
settings according to their personal preferences.
In its most basic form,
buy and sell signals can be generated by +DI/-DI crosses. A buy signal occurs
when +DI moves above -DI and a sell signal when -DI moves above the +DI. Be
careful, though; when a security is in a trading range, this system may produce
many whipsaws. As with most technical indicators, +DI/-DI crosses should be
used in conjunction with other aspects of technical analysis.
The ADX combines +DI
with -DI, and then smoothes the data with a moving average to provide a
measurement of trend strength. Because it uses both +DI and -DI, ADX does not
offer any indication of trend direction, just strength. Generally, readings
above 40 indicate a strong trend and readings below 20 a weak trend. To catch a
trend in its early stages, you might look for stocks with ADX that advances
above 20. Conversely, an ADX decline from above 40 might signal that the
current trend is weakening and a trading range is developing.
The Average
Directional Index (ADX) and SharpCharts
With SharpCharts, you can plot the +DI/-DI using
the Wilder's DMI (ADX) indicator above, below, or behind the price plot chart.
The Parameters text box controls the number of periods used to calculate the
ADX, with the default being 14. The Position drop-down menu controls the
positioning of the indicator.
Bear in mind that increasing the number of
periods will smooth the ADX line (making it less volatile), and display more
significant readings. The readings, however, will present more of a lag. For
example, if charting 30 periods, readings over 40 become stronger indicators of
a trend. However, the trend may have already started and could have been caught
earlier less periods were used.