Direction is the Key to Using ADX Correctly

By Chuck LeBeau

I have been trading with Wilder’s Averaged Directional Index (ADX), sometimes known
as the Directional Movement Indicator (DMI), for more than twenty years and have
written and lectured about my findings throughout the world. I would hope that my
public fondness for this indicator has contributed to its increasing popularity among
knowledgeable technicians. However I continue to see evidence that the ADX is not well
understood and is often used incorrectly. In this brief article I would like to point out a
very common misconception about ADX and explain how to correctly interpret the vital
information provided by this most valuable technical tool.

As most technicians already know, the ADX is an indicator that measures trendiness. But
to do its job most effectively it needs to be interpreted correctly. Unfortunately the
inventor, J. Welles Wilder Jr., got our basic understanding of his ingenious indicator off
to a bad start by explaining that the level of the ADX is what we need to be concerned
with. If you are acquainted with Wilder’s book, New Concepts in Technical Analysis that
first introduced the ADX/DMI and I asked you: “Which is more predictive of a trending
market; an ADX of 20 or an ADX of 30?” You would probably not hesitate to respond
that the higher level of 30 would obviously be more predictive of trendiness than the
lower level. However that is not necessarily correct because it is not the level of the
ADX but its direction that provides the predictive information we seek. An ADX of 20
that is rising steeply is much more predictive of trendiness than an ADX of 40 that is flat
or declining. Traders and technicians need to understand that regardless of the absolute
level of ADX, if it is sloping upward the market is increasing its trendiness and if the
ADX is declining the market is losing trendiness.

Once this vital distinction between the level of the ADX and the direction of ADX is
understood we can carry this directional logic an important step further. An ADX that is
rising rapidly is more predictive of trendiness than an ADX that is rising slowly. Let’s
get into some specifics now. In my experience with ADX using Wilder’s default period
of 14 bars I have found that any upward movement from the previous bar of 0.25 or
greater is significant and tells us that a trend is underway. If the change from the
previous bar is greater, say 0.50 or more, then that higher rate of change indicates that an
even stronger trend is in place. In fact I have observed that many of the strongest and
longest lasting trends will start with a rise in the ADX of 1.00 or more from bar to bar.

Unfortunately a few of the popular software providers, MetaStock in particular, follow

Wilder’s original instructions which called for rounding the ADX to the nearest whole
number. Rounding causes serious problems when trying to measure the critical rate of
change. For example a significant upward move from 25.05 to 25.35 leaves the rounded
ADX unchanged at 25 while an insignificant move from 25.45 to 25.55 jumps the ADX a
whole point from 25 to 26. To use the ADX correctly we must carry the calculations out
to at least two decimal places. I have pointed out this problem to the folks at MetaStock
numerous times over the years and as far as I know they have yet to revise their formula.
Fortunately most other software providers now carry their calculations out to the required
two or three decimal places and there are many places on the web where ADX can be
obtained for free.

I primarily rely on the ADX for entry signals and have not found it to be of much value
after the trade has been initiated. Exit strategies generally require more precise timing
than the slow moving ADX can provide. The ADX is a very robust indicator and I have
had good results using ADX setting as short as 7 bars and as long as 30 bars. The fact
that the ADX produces good results regardless of its exact parameter setting is a tribute to
its robustness and reliability. Reliable indicators should work well over a wide range of
settings. Beware of indicators that require very precise parameter setting to work
effectively.

Here are a few more tips that may be helpful to users of ADX:

Profit targets: When the ADX is rising you should be applying trend-following
strategies and looking for fairly substantial profits of four Average True Ranges or more.
When the ADX is flat or declining then trend following strategies will fail. Under these
conditions you will need to find another market where the ADX is rising or switch
strategies and apply short term counter-trend methods with profit targets of only 1.5
ATRs or less.

Major trend reversals: When the ADX is above 35 and it is higher than either the Plus
DI or the Minus DI then extreme caution is in order because many important trend
reversals occur at these extremes. When the ADX is above both the Plus DI and the
Minus DI I suggest using a very sensitive indicator (such as the Parabolic) to quickly
signal a possible change in the primary direction. This technique can identify many
major tops and bottoms particularly in stock index markets.

I hope that this brief article will help you get better results with my favorite technical
indicator. I don’t know how anyone can trade without looking at ADX before they trade.
It provides critical information that all traders can use.

A PowerPoint presentation about ADX is available at no charge if you send an email

request to me at clebeau2@cableone.net.