The Directional Movement System is composed of three distinct indicators;
- Plus Directional Indicator (DI+)
- Minus Directional Indicator (DI-)
- Average Directional Movement Index (ADX)
Wilder designed ADX having in mind commodities and currency trading and also considering daily prices, even though today the oscillator is used for all kinds of traded instruments in various time frames.
The Directional Movement system is designed to primarily determine whether a traded instrument is trending and if so in what direction.
The Average Directional Index (ADX) measures trend strength regardless of trend direction, while the two Directional Indicators - "DI+" and "DI-" - aim to define trend direction. Used together, they form a powerful trading system that can help determine both the strength and the direction of a trend.
Wilder determined directional movement by comparing the difference between two consecutive highs with the difference between the lows during the same period.
Where, DM+ = High(t) - High(t-1) and DM- = Low(t) - Low(t-1)
If the price has moved up, then “DM+” is taken as the difference between the present high and previous high. In the same way, if the price has moved down, the distance between the present low and previous low is taken as “DM-”.
The Directional Movement Index “DI+” / “DI-” is calculated as a percentage of the true range, that is the range of highs/lows divided by the price range over the last period and previous close, smoothed over a given number of periods.
True Range (TRt) is the true range for a given period. It is a measure of volatility and it equals the largest of the three measures noted below:
- Maximum of: Hight - Lowt or Hight - Lowt-1 or Closet - Lowt
- Note that both “DI+” and “DI-” are positive numbers.
- Both Plus Directional Indicator (“DI+”) and Minus Directional Indicator (“DI-”) are positive numbers.
Are used to calculate ADX or Average Directional Movement Index, which indicates the strength of the trend.
The Directional Movement Index:
The Average Directional Index (ADX) is then calculated as a smoother version of DX, over a given period of time.
A full guide to the calculation and construction of all ADX System indicators is provided in excel format for your better understanding.
Interpretation & Trade Signals
- If the market is trending – in either direction – the ADX line should be rising.
- An ADX below 20 indicates that there is no trend or the existing trend is weak.
- In this case, range-trading strategies should be used.
An ADX above 25 and rising towards the 40 points level indicates that this is a trending market and trend-following approaches should be used (e.g. Moving Average., Parabolic SAR).
An ADX above 40-50 points could indicate overbought/oversold market conditions and you should be preparing for profit collection. A sudden downturn in the indicator’s value, accompanied by a Directional Indices’ crossover and confirmed by other reversal patterns may signal an imminent trend reversal.
During extended consolidation periods, the ADX line will slip towards a low number. A move below 10 points may be a warning of a significant market move to either direction.
As long as you see that the ADX is rising, don’t use oscillations. Use ADX as filter between oscillations and trend indicators.
As indicated earlier, ADX does not convey any information about the trend direction. Directional movement is defined by DI+ and DI-.
Directional Movement Indices
In the most basic form, buy and sell signals can be generated by DI+/ DI- crosses.
When an uptrend changes to downtrend, DI- crosses above DI+ and when the downtrend changes to uptrend, DI+ crosses above DI-.
The wider apart they are, the stronger the trend. The narrower they are, the weaker the trend.
It is preferable to disregard any DI+/ DI- crosses when ADX is below 20 points since the trend is weak and unreliable.
Trading ADX system signals
Provided ADX indicates the existence of a trend, a long trade is taken when DI+ crosses above DI- and a short trade is taken when DI- crosses above DI+.
Trade Initiation: Enter the trade on the break of the high of the bar when a signal is given if trading the long side, or on the break of the low of the bar when a signal is given when trading the short side.
Stop Loss Policy: Wilder based the initial stop on the low of the signal day for buying or the high on the day of the sell signal.
Place the stop below the entry bar low (above the entry bar high for shorts), or alternatively use Parabolic SAR, or prices/Moving average crossover for stop trigger.
If after a trade signal another opposite crossover happens in a short period of time, the original signal should be disregarded and the position hedged.
Do not make trading decisions based on any one indicator alone.
- Long Entry signal: DI+>DI- and ADX bottoming and rising. Trending confirmation when ADX>20
- Change of trend warning: ADX>40 and showing definite signs of reversal
- Long Exit signal: DI->DI+ and ADX<40 and falling
Tips and ideas
While Wilder suggested using 14 periods for the ADX for the daily time-frame, in the case of intraday trading, you would consider altering this default setting in order to increase/decrease the sensitivity of the system. In other words you can optimise the system through backtesting.
While ADX can be plotted above, below or behind the main price chart, it is recommended not to plot in the main price chart because of the three lines involved.
Horizontal lines can be added to help identify ADX signals. The example provided here shows the 20-25 points and the 40-50 point important levels.
DI+/ DI- and ADX provide a quick and reliable way to test whether a market is trending or not, which is extremely important in helping us decide which type of trading approach might be the most effective under current conditions.
A trader can stay with trending positions longer by following the ADX line since it filters out a lot of false signals frequently given early in a move, in contrast with faster reacting oscillators.
Price - Moving Average crossover signals can be used for confirmation help.
Basic trend analysis and reversal patterns can help distinguish strong crossover signals from weak crossover signals.
Suggested Combinations for EA development
Support/Resistance levels, continuation & reversal patterns, retracement zones.
Wilders Parabolic SAR can be used to set a trailing stop-loss.
DI+ and DI- crossovers are quite frequent and one needs to filter these signals with complementary analysis. Setting an ADX requirement filters out some of the signals, but since it is a lagging indicator, sometimes it tends to filter out valid signals as well. Not very helpful during sideway markets or during extended consolidation periods and ADX will assume low prices.