The ADX indicator is actually a suite of indicators meant to measure whether or not the asset under study is in a trending mode. It is a fairly slow indicator and one must be careful in applying it because it takes time to adjust to market moves. Whipsaws are possible, and in fact likely if the market is in a wide trading range.

The components of the index are:

DIRECTIONAL MOVEMENT (+DM and -DM) -- This indicator represents the largest part of today's move that is outside the previous day's range. So, for example, if yesterday's price range was 18-22 and today's is 17-24, then +DM is two and -DM for the day is zero. On an inside day, there is no directional movement. This system does not care where the close is, so in the example above, even if the close was on the low, the directional movement is considered to be positive because the largest part of today's range is above the previous session's range. Note that -DM is always positive, so if today's range is 17-20 and yesterday's was 19-19 1/2, then -DM is two and +DM is zero.

DIRECTIONAL MOVEMENT INDICES (+DI and -DI) -- This indicator is computed by using the daily +DM and -DM discussed above and taking a ratio with the daily true range. The daily true range is the largest of the following: The absolute value of:

A. The distance from today's high to today's low.
B. The distance from today's high to yesterday's close.
C. The distance from today's low to yesterday's close.

What the true range does is adjust for gaps by, in essence, adding them back into today's trading range. We then compute today's +DI and -DI as the ratio of the DM's to the daily true range (TR), so:

+DI =+DM/TR and -DI = -DM/TR

This indicator tells you how powerful today's move was in comparison to the day's range. On a day in which prices gap higher and close at the high, that day's +DI would be 1.00. Remember, on an inside day, both DI's will be zero, and if there is positive directional movement, then there can be no negative directional movement.

SMOOTHED DI's -- These are computed by taking a 14-day moving average of the individual DI's (exponential moving averages are preferred, but it does not make that much of a difference).

DIRECTIONAL INDICATOR (DX) -- This is the ratio of the difference between the smoothed +DI and -DI and the total directional movement. That is:

DX = [+DI(14) - -DI(14)] / [+DI(14) + -DI(14)]

Note: +DI(14) is the 14-day smoothed positive directional movement index and -DI(14) is the 14-day smoothed negative directional movement index. These are the standard numbers.

AVERAGE DIRECTIONAL INDEX (ADX) -- This is just the smoothed DX (again, typically a 14-day exponential smoothing factor).

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WHAT DOES ADX TELL YOU?
First of all, remember that this is a very slow indicator, so it is not going to turn at tops or bottoms. I mostly use ADX as a secondary indicator to tell me whether we are in a trend. Then I will look at the +DI and -DI to see what the components look like. The classic rules are that a move past 20 in ADX says that the trend is real and that moves above 40 should be treated suspiciously and might mean that the move is stretched. Some people get into a directional move on a run past 20 in ADX.

Alexander Elder, in his book Trading for a Living suggests going with the trend whenever ADX breaks from a low level and from beneath both directional lines and then ratchets up four points -- this is a sign that a new trend is starting. He also warns that when ADX is above both DI lines, then the trend is ahead of itself. He suggests getting out of a trade when ADX turns lower from such a position.

I mostly use ADX to see the direction of the three lines as compared to the current trend. When ADX starts to turn from an extreme level, then that can be a warning of a change in the trend for the next several months. ADX is never a determinant in my thinking because it is such a slow-moving indicator, but I do use it to see how well my larger Elliott Wave counts fit with the indicator. In addition, I often use it to confirm other technical ideas.

If you look at the chart for XLE in this week's trade, then you will note that ADX is very high (at 47.02) and is off very slightly from its high. Also, note that ADX sits at higher levels than +DI and –DI (the next panel down). This, coupled with the move off channel resistance, momentum divergences, and the other items I listed are what led me to short that ETF.

Steven Poser
Editor
The ETF Authority
New York, NY

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