Average Directional Index
This Indicator was also developed by J. Welles Wilder and mentioned in his famous 1978 book, New Concepts in Technical Trading Systems. This book also includes details on the Average True Range (ATR), known in Portuguese as Average Range of Variation, Parabolic SAR and RSI. And even though Wilder's indicators were developed before the computer age, they are still widely used today.
The Medium Directional Index (ADX) consists of three lines to help users identify the direction and strength of trends. By default, the indicator uses data from more periods.
- The ADX line helps to determine the strength of the trend.
- And what it calls DI + lines and DI-, help to identify the trend direction.
Then it is plotted in its own window as can be seen in the graph below:
Wilder states that if the reading of the ADX line is above 20 then it indicates trends and attention should be paid even to the entry points of up and down. If it is below 20 there is no trend and most traders should stay away from the market. In terms of D lines, if the DI + is above the DI- then, the bulls are stronger and the market is rising but if the -DI is above the + DI then the market trend tends to be downward.
To identify entries, you can use the DI + and DI- crossing system, which is very simple. When the DI + crosses over the DI-, it may indicate potential purchase. Likewise, if DI + crosses below DI-, then it can indicate sales opportunities. However, this method can generate many input signals in a short period of time, which can generate bad input signals. To avoid this, you should always try to follow the biggest trend and it may be best to follow a moving average to determine the overall trend and open positions only in that direction.
This is a more advanced indicator of Welles Wilder and is not as well known as other indicators in the same book such as RSI and ATR. However, it can be very useful for experienced traders and provides a guide to both the direction and strength of the trend. In addition, it offers a greater number of signals than many other indicators, so if you want to operate more aggressively, often a day or week, then ADX can be useful. Most people, however, are likely to apply ADX as a trend-following indicator.