Average Directional Index – ADX
The average
directional movement index (ADX)
was developed in 1978 by J. Welles Wilder as
an indicator of trend strength in a series of prices of a financial instrument.
Analysis of ADX is a method of evaluating trend and can help traders to choose
the strongest trends and also how to let profits run when the trend is strong.
ADX has become a widely used indicator for technical analysts, and is provided
as a standard in collections of indicators offered by various trading
platforms.
Calculation:
The ADX is a combination of two other
indicators developed by Wilder, the positive directional indicator (abbreviated
+DI) and negative directional indicator (-DI). The ADX combines them and
smooths the result with an exponential moving average.
To calculate +DI and −DI, one needs price data consisting of high, low, and closing prices each period (typically each day). One first calculates the directional movement (+DM and −DM):
UpMove = today's high − yesterday's high
DownMove = yesterday's low − today's low
if UpMove > DownMove
and UpMove > 0, then +DM = UpMove,
else +DM = 0
if DownMove > UpMove and DownMove > 0, then
−DM = DownMove, else −DM = 0
After selecting the number of periods (Wilder used 14 days originally),
+DI and −DI are:
+DI = 100 times exponential moving average of (+DM) divided by average
true range
-DI = 100 times exponential moving
average of (−DM) divided by average true range
The smoothed moving average is calculated over the number of periods
selected, and the average true range is an exponential average of the true
ranges. Then:
ADX = 100 times the smoothed moving average
of the absolute value of (+DI − −DI)
divided by (+DI + −DI)
Variations
of this calculation typically involve using different types of moving averages,
such as a weighted moving average or an adaptive moving average.
What is specific about the Average Directional Movement Index is that it
does not point out the direction of the trend, rather its strength, and its
main purpose is to estimate the different phases of that trend. You can see on
the screenshot below that the ADX alone tells you nothing more but how strong
the price momentum is.
An indicator used in technical analysis as an objective value for the
strength of trend. ADX is non-directional so it will quantify a trend's
strength regardless of whether it is up or down. ADX is usually plotted in a
chart window along with two lines known as the DMI (Directional Movement
Indicators). ADX is derived from the relationship of the DMI lines.
Interpretation
The ADX does not indicate trend
direction or momentum, only trend strength. It is a lagging indicator; that is,
a trend must have established itself before the ADX will generate a signal that
a trend is under way. ADX will range between 0 and 100. Generally, ADX readings
below 20 indicate trend weakness, and readings above 40 indicate trend
strength. An extremely strong trend is indicated by readings above 50.
Alternative interpretations have also been proposed and accepted among
technical analysts. For example it has been shown how ADX is a reliable
coincident indicator of classical chart pattern development, whereby ADX
readings below 20 occur just prior to pattern breakouts.
Timing
Various market timing methods have been devised using ADX. One of these methods is discussed by Alexander Elder in his book
"Trading for a Living". According to Elder, there is a buy signal when the ADX peaks and starts to decline when the +DI is above the -DI. With this strategy you would sell when the ADX stops falling and goes flat.
References:-
http://en.wikipedia.org/wiki/Commodity_channel_index
http://www.investopedia.com/terms/a/adx.asp