Dave Landry: Finding The Strongest Trends With ADX

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.

Dave Landry is principal of Sentive Trading, a money management firm, and a principal of Harvest Capital Management. Mr. Landry is the author of two top selling books, “Dave Landry’s 10 Best Swing Trader Patterns And Strategies” and “Dave Landry On Swing Trading.” His website is www.davelandry.com.

 

 

 

 

http://www.tradingmarkets.com/.site/stocks/how_to/articles/Finding_The_Strongest_Trends_With_ADX.cfm

Tuesday, August 9th, 2011 Uncategorized

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