Average directional index (ADX)
The Directional Movement Index (DMI) helps determine if a security is "trending" or "trading" (moving sideways). It was developed by Welles Wilder and explained in his book, new Concepts in Technical Trading Systems. The Average Directional Index (ADX) is an MA of DMI that evaluates the strength of the current uptrend or downtrend as well as evaluates whether the stock is "trending" or "trading".
How it is calculated
ADX is an oscillator that measures the directional change or movement of an issue on a scale of 0 - 100. ADX is calculated with the following formula:
Notice from the above formula, there are two DIs, namely +DI and -DI. Since the raw data derived from the calculation are unduly volatile, they are each calculated as an average over a specific time period and the result is plotted in the same chart panel with ADX (Pring 2002).
Again, the normal default time span is 14 days (Pring 2002).
How to interpret
Unlike other oscillators, ADX tells us nothing about the direction in which a price is moving, only its trending or non-trending characteristics. Use other oscillators for this task (Pring 2002).
ADX readings below 20 indicate a weak trend; whereas readings above 40 indicate a strong trend. The indicator does not tell whether the trend is bullish or bearish, but merely assesses the strength of the current trend. Thus, a reading above 40 can indicate either a strong downtrend or a strong uptrend.
ADX can also be used to identify potential changes, i.e. from "trending" to "trading" .When ADX begins to move downward from 40, it is a sign that the current trend is losing strength and a trading range could develop.
In similar vein, when ADX begins to move upward from 20, it is a sign that the trading range is ending and a trend could be developing. But what trend? An uptrend or downtrend ? The answer lay in monitoring the two DIs and the price (Pring 2002).