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Average Directional Index: Unique Indicator Helps Traders Avoid 'Dead Money' Stocks
The Average Directional Index (ADX) is one of the few technical indicators that measure the strength of the trend independent of price. This means that the value of ADX tells you whether the stock, future or index being analyzed is trending. ADX does not offer any insight into the direction of the trend, and a high ADX can be seen whenever prices are moving up or down.
ADX is calculated from the Directional Movement Index (DMI). DMI plus (+DI) and DMI minus (-DI) are two indicators that are defined in the Directional Movement Index article. All three of these tools were introduced in J. Welles Wilder's 1978 book, New Concepts in Technical Trading Systems. Wilder applied the indicators to futures, but they are now widely applied to individual stocks, ETFs and indexes.
The calculations are complex and the indicator is readily available at charting sites or in charting software packages. In general, finding ADX involves combining exponential moving averages (EMAs) of +DI, -DI and the daily ADX to create a smoothed indicator that rises when prices are in a strong trend. The default values for all of the inputs are 14 days, although any other time period can be used.
Some traders take a 14-day EMA of the ADX to create a smoother version of the indicator known as Average Directional Movement Rating (ADXR). Because so many variables are involved in the calculation, ADX already has a significant lag to the market action and ADXR increases that lag.
A lag means that the indicator will give a signal after the price action has already turned. Using ADXR delays the timing of the ADX signal and usually results in lower trading profits. Some traders use ADX with a shorter time period, like 7 or 10 days, to reduce the lag in the signal.
How Traders Use It
Many traders use ADX to identify the best trading candidates. Traders make money only when the price is moving and ADX points to the most volatile periods of market activity. Some traders will scan for the stocks or futures with the highest ADX while others use a static level to help them spot trading opportunities.
A static value for determining trendiness was the original method described by Wilder. He noted that a strong trend is under way whenever ADX is above 25 and the market is trendless when ADX falls below 20. Wilder did not address what ADX means when the value is between 20 and 25.
ADX highlights strong trends, but other indicators are needed to decide whether the trend is up or down. In the chart below, ADX indicated that a tradable trend was under way in the SPDR Gold Shares (NYSE: GLD), but ADX remained above 25 through the bubble-like push to the top and the subsequent crash. Moving averages or indicators like stochastics would need to be added to the analysis process when deciding whether GLD should be bought or sold.
Why It Matters To Traders
Traders make money in trends. Being long or short a security that is in a narrow trading range ties up trading capital and keeps the trader out of other positions that could be more profitable. ADX is one of the few tools a trader has to objectively identify trends and this can help them limit trades in "dead money" securities that have little volatility and low potential profitability.