Today’s Trading Lesson From Tradingmarkets

Editor’s Note:

Brice

The Average Directional Movement Index (ADX) measures the trend strength of a
market but not its direction. The higher the ADX reading, the stronger the
trend, regardless if it is up or down.

The ADX, which was developed by Welles Wilder, uses calculations called the
positive directional movement index (+DMI) and minus directional movement index
(-DMI) to measure price movement. Although the entire ADX calculation is
somewhat lengthy and complex, understanding the basis of the
calculation–directional movement–is fairly straightforward and will help you
understand how the indicator works.

Below we will show you how to determine the directional movement and
interpret ADX readings.

Understanding directional movement

Directional movement is essentially the part of a price bar that falls
outside of the prior price bar’s range. In terms of a daily chart, price action
above yesterday’s high is positive directional movement (+DM), while anything
below yesterday’s low is negative directional movement (-DM).

 

Figure 1. Directional Movement (DM). Price action above yesterday’s high is +DM while that below yesterday’s low is -DM. Source: Omega Research.

In Figure 1, notice the box a-b above yesterday’s price. For today,
anything above yesterday’s high (for instance, if the market trades from a
to b is +DM. Conversely, anything trading below yesterday’s low (for
instance, if the market trades from c to d is -DM.

 

Figure 2. Plus Directional Movement (+DM). Source: Omega Research.

Notice in Figure 2 that the price bar trades above the prior price bar (from a
to b). This distance is the +DM. Referring to Figure 3, the range of the
bar that trades below the prior day’s low (from c to d) is the
-DM.

 

Figure 3. Minus Directional Movement (-DM). Source: Omega Research.

Obviously, not every trading day sets up like Figures 2 or 3. Therefore, we
must consider two other possibilities: inside days and outside days. An inside
day occurs when the entire day’s range is “contained” within the prior
day’s high and low. In other words, today’s high is less than yesterday’s high
and today’s low is greater than yesterdays low. For example, if XYZ traded
yesterday between 50 and 60 and trades today between 51 and 59, then today is an
inside day. In Figure 4, notice there is no DM (either + or -) because the range
doesn’t trade above (for a +DM reading) or below (for a -DM reading).

 

Figure 4. Inside days have no Directional Movement value. Source: Omega Research.

An outside day occurs when today’s high is higher than yesterday’s high and
today’s low is lower than yesterday’s low. For instance, if XYZ traded between
50 and 55 yesterday and between 49 and 56 today, today is an outside day because
today’s range is “outside” yesterday’s. Because there can only be one
directional movement (either + or -) per trading day, the outside day presents
an interesting problem because it contains both +DM (today’s high greater than
yesterday’s high) and -DM (today’s low greater than yesterday’s low). Because we
are looking to quantify movement in price, on an outside day the largest
move–either the difference between today’s high and yesterday’s high or the
difference between yesterday’s low and today’s low–is the directional movement.
This is illustrated in Figure 5. In the rare case that the move above
yesterday’s high is equal to the move below yesterday’s low then there would be
no DM for that day.

 

Figure 5. For outside days, the Directional Movement is the greater of the +DM or the -DM. Source: Omega Research.

Directional Movement (DM) summary:

1. Today’s high > yesterday’s high (and today’s low > yesterday’s low)
   = +DM
   
2. Today’s low < yesterday's low (and today's high < yesterday's high)
   = -DM
   
3. Inside day (today’s low > yesterday’s low and today’s high <
   yesterday’s high) = no DM (either +DM or – DM)
   
4. For outside days, take the larger of today’s high – yesterday’s high or
   yesterday’s low – today’s low. If these figures are equal, there is no DM.

To make the directional movement readings meaningful for all markets, Wilder
divided the DM by the market’s true
range. This creates a directional movement indicator (DMI) in a form of a
ratio and allows for meaningful comparisons regardless of various market prices.
In other words, the DMI of a $5 stock can be compared to the DMI of a $100
stock.

Because one day does not a trend make, the DMI is then averaged over a number
of days. The magnitude of the trend reflected by the ADX–longer-term or
shorter-term–depends on the number of days in this calculation. Wilder’s
default, and the number widely used by charting software packages (and
TradingMarkets.com), is 14 days.

The Average Directional Movement Index (ADX) is then calculated by taking the
difference between the smoothed +DMI and -DMI calculations. It’s obvious the ADX
calculation is very complex, but if you understand the directional movement
detailed previously, you’ll have a good understanding of how the indicator works
and enough background to use it.

 

Figure 6. Amazon.com, daily. +DMI greater than -DMI reflects an uptrending market. Source: Omega Research.

The ADX measures trend strength but not direction. The direction of the
market is determined by comparing the +DMI to the -DMI. If the +DMI is greater
than the -DMI the market is in an uptrend; if the -DMI is greater than the +DMI
the market is in a downtrend. Referring to Figure 6, notice that the +DMI is
greater than the -DMI signifying and uptrend. Also, notice that the ADX rose to
relatively high levels (above 30) as the trend remained strong and the stock
quadrupled in value. On the downside, in Figure 7, notice that the -DMI is
greater than the +DMI as the ADX remained above relatively high levels (above
30) as the stock continued to decline.

 

Figure 7. Iridium, daily. A downtrend is reflected by a -DMI reading greater than the +DMI reading. Note that the ADX reading, signifying trend strength, is high. Source: Omega Research.

One word of caution: Many trading books would have you believe you can simply
buy a market when the +DMI crosses above the -DMI and sell the market when the -DMI
crosses below the +DMI. They go on to show well-chosen examples where you could
have followed this simple system and made large sums of money. However, nothing
could be further from the truth. What they fail to show you is how much money
you would lose as the DMIs cross back and forth.

Using the ADX

High ADX readings reflect a strongly trending market. Conversely, low ADX
numbers reflect non-trending markets. The minimum reading to determine a
“trend” is subject to debate. In general, 14-day ADX readings above 30
suggest a strongly trending market. Those who only wish to trade the strongest
of markets may look for readings of 35 or higher. The trade-off here is that the
stronger the number, the longer the trend has been in place. Therefore, much of
the original move (that caused the ADX to rise) is missed. Those who look to
catch early trends may look for markets with an ADX of 25 or higher. Not
surprisingly, the trade-off here is that these markets are more prone to failure
because they have yet to “prove” themselves.

The advantage of the ADX is that it provides a standardized way of measuring
trend. This lends itself well to computerized scans for finding trending markets
(i.e., the TradingMarkets.com ADX Search and Filter). These markets can then be
watched for potential entries signals from breakouts, pullbacks, cup-and-handle
patterns, and so forth. Counter-trend traders, those who tend to fade markets
(trade opposite to the trend) may look to trade markets that are in a trading
range or no trending as measured by a low ADX reading.

Summary

The ADX is based on the directional movement, positive or negative of a
market. The positive directional movement is the portion of today’s range that
is above yesterday’s high. The negative directional movement is the portion of
today’s range that falls below yesterday’s low.

Only one directional movement is calculated for each day. Therefore, if there
are both +DMI and -DMI for a given day (i.e., an outside day) then the larger of
the two becomes the directional movement. If today’s range does not trade above
or below the prior day (i.e., an inside day) then there is no directional
movement for that day.

The ADX is calculated by taking the difference of the average directional
movement values over a given time period. The ADX measures trend but not
direction. The direction of the market is determined by comparing the +DMI to
the -DMI. If the +DMI is greater than the -DMI the market is uptrending; if the
-DMI is greater than the +DMI the market is downtrending. High ADX readings
suggest a market is in a strong trend and low ADX numbers suggest a market is
not trending.