Follow this thread for a step-by-step guide on how to calculate, interpret, and apply ADX to both OHLC and PnF charts. Plus, discover how to use ADX for indicative scans.
#ADX #TechnicalAnalysis #Trading
#ADX #TechnicalAnalysis #Trading
This thread includes a study of Welles Wilder from his book ‘New Concepts in Technical Trading System’ on the Average Directional Index (ADX). This book also includes details on Average True Range (ATR), the Parabolic SAR system, and RSI.
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This thread is going to be comparatively longer than my other written threads. So to make your learning easy, I have inserted a thread index for your navigation and quick revisits.
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Index:
5 to 10: Background
11 to 16: Calculation of +DMI
17 to 20: Calculation of -DMI
21 to 25: Calculation of ADX
26 to 32: Interpretation
5 to 10: Background
11 to 16: Calculation of +DMI
17 to 20: Calculation of -DMI
21 to 25: Calculation of ADX
26 to 32: Interpretation
Let us begin our learning on ADX and how you can use it for your trading.
The Average Directional Index (ADX) is a technical indicator that is used to measure the strength of a trend.
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The Average Directional Index (ADX) is a technical indicator that is used to measure the strength of a trend.
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The Average Directional Index (ADX), Minus Directional Indicator (-DI), and Plus Directional Indicator (+DI) represent a group of directional movement indicators that form a trading system developed by Welles Wilder.
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Positive and negative directional movement form the backbone of the Directional Movement System. Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between their respective highs.
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Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI) are derived from smoothed averages of these differences and measure trend direction over time. These two indicators are often collectively referred to as the Directional Movement Indicator (DMI).
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The Average Directional Index (ADX) is in turn derived from the smoothed averages of the difference between +DI and -DI; it measures the strength of the trend (regardless of direction) over time.
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Using these three indicators together, analysts can determine both the direction and strength of the trend.
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As we have understood the background, let us now deep dive into the calculation of the indicator. I put a lot of emphasis on calculation as this help is developing our cognitive ability and helps us to take better trading decisions.
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Directional movement is calculated by comparing the difference between two consecutive lows with the difference between their respective highs.
Three lines:
+DMI: Positive Directional Movement Indicator
-DMI: Negative Directional Movement Indicator
ADX: Smoothing line of DMI
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Three lines:
+DMI: Positive Directional Movement Indicator
-DMI: Negative Directional Movement Indicator
ADX: Smoothing line of DMI
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+DMI (Positive Directional Movement Indicator) is one of the two lines used to calculate the Average Directional Index (ADX). It is used to measure the bullish strength of a trend.
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It is calculated as follows:
+DM = Current High - Previous High (if Current High > Previous High)
+DM = 0 (if Current High <= Previous High)
TR = Max(Current High - Current Low, abs(Current High - Previous Close), abs(Current Low - Previous Close))
+DMI = 100 * (+DM / TR)
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+DM = Current High - Previous High (if Current High > Previous High)
+DM = 0 (if Current High <= Previous High)
TR = Max(Current High - Current Low, abs(Current High - Previous Close), abs(Current Low - Previous Close))
+DMI = 100 * (+DM / TR)
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Where,
+DM --> positive directional movement
TR --> True Range
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+DM --> positive directional movement
TR --> True Range
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It is important to note that +DMI line is not a standalone indicator, it is used along with -DMI line in calculating ADX.
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-DMI (Negative Directional Movement Indicator) is one of the two lines used to calculate the Average Directional Index (ADX). It is used to measure the bearish strength of a trend.
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It is calculated as follows:
-DM = Previous Low - Current Low (if Current Low < Previous Low)
-DM = 0 (if Current Low >= Previous Low)
ATR = Max(Current High - Current Low, abs(Current High - Previous Close), abs(Current Low - Previous Close))
-DMI = 100 * (-DM / ATR)
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-DM = Previous Low - Current Low (if Current Low < Previous Low)
-DM = 0 (if Current Low >= Previous Low)
ATR = Max(Current High - Current Low, abs(Current High - Previous Close), abs(Current Low - Previous Close))
-DMI = 100 * (-DM / ATR)
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Where,
-DM --> negative directional movement
TR--> True Range
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-DM --> negative directional movement
TR--> True Range
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It is important to note that -DMI line is not a standalone indicator, it is used along with +DMI line in calculating ADX.
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The Average Directional Index (ADX) is calculated based on the difference between two Exponential Moving Averages (EMAs) of the difference between two successive lines, +DMI and -DMI. The ADX value ranges from 0 to 100.
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The calculation is as follows:
First, you need to calculate +DMI and -DMI lines.
Next, you take the absolute value of the difference between +DMI and -DMI, which is the (+DMI - -DMI)
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First, you need to calculate +DMI and -DMI lines.
Next, you take the absolute value of the difference between +DMI and -DMI, which is the (+DMI - -DMI)
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Then you take the 14-day EMA of the above result
Then you calculate the 14-day EMA of the above EMA
Finally, ADX = 100 * (EMA of (+DMI - -DMI) / (|+DMI - -DMI|))
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Then you calculate the 14-day EMA of the above EMA
Finally, ADX = 100 * (EMA of (+DMI - -DMI) / (|+DMI - -DMI|))
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Important to note that 14 days is a common period used for the EMA, but other periods can also be used depending on the trader's preference. Also, ADX is a lagging indicator, it will confirm a trend after it has already started, but it will not predict future trend direction.
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Formulae used for calculating +DMI, -DMI, and ADX
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Let us now understand the application and interpretations of ADX indicator
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Interpretation-1: To measure the strength of a trend in the market. It can help traders determine if a market is trending or non-trending, and how strong the trend is. I have explained it with help of below image.
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Interpretation-2: When both the DMIs are below 25 there is no trend in the market
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Interpretation-3: Dominant DMI
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Interpretation-4: When ADX moves above 25 levels trend starts in the Dominant DMI direction
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Interpretation-5: Crossover in DMI (when ADX is above 25) shows the change in Trend.
+DI moves above the −DI ➡️ buying trend is more likely to extend into the future.
−DI crosses above the +DI ➡️ downtrend is getting stronger, and traders can open sell trades now.
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+DI moves above the −DI ➡️ buying trend is more likely to extend into the future.
−DI crosses above the +DI ➡️ downtrend is getting stronger, and traders can open sell trades now.
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Interpretation-6: If DMIs crosses below 25 and HOLDS the cross above 25, the cross can be treated as a VALID Cross
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Summary for trading using ADX levels
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In my next thread, I will delve deeper into utilizing ADX in trading and share additional examples to help you in implementing this concept in your strategy. If you found this thread informative, please share it with others by retweeting it to help me reach a larger audience.
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