History
Average Directional Index (ADX)
was developed by J. Welles Wilder Jr. and as its name
implies attempts to measure the strength of the direction
the security is moving in.
ADX is measured in a scale
from 0-100 with readings above 25 indicating that you are in
a trend whilst readings below 25 indicate that you are not
in a trend. As the scale is measured from 0-100 it doesn't
matter if the trend is up or down, the scale and reading are
still from 0-100 e.g. if you were in a strong down trend the
reading might be 45. You might get the exact same reading if
you were in a strong up trend. The reason I mention this is
that many of my students get confused when first introduced
to ADX and see the indicator rising as the trend goes down
(see chart below).
DJIA
Wilder himself admitted that
''Directional movement is the most fascinating concept I
have ever studied'' 'New Concepts In Technical Trading
Systems'. Readings of over 60 are fairly rare in my
observations and once they are at the extremes can actually
mean the direction is getting ready for a change.
My Own use Of ADX
I highly recommend this
little technique. You may not get that many signals but when
you do they will be high probability. I like to use a 21
period moving average on the time period I am trading.
First the ADX must be 30 or
over, no action is taken unless the ADX has achieved this
reading.
Next the security must
retrace to its 21 period moving average.
Once these two conditions
have been met you can enter the market. Once in the market
keep two things in mind. Have a tight stop on the initial
entry, perhaps above the most recent high or most recent low
depending on direction you are trading or even a dollar
amount.
Next, be aware of the last
high or low once in trade e.g. the ADX has a reading 30 or
above, the security makes a high and then retraces to the 21
period moving average. Your first target should be the last
high or you should at least pay close attention to what
happens to price around that level.
The same goes for the short
trade. You have a reading of 30 or above and it makes a new
low. It then pulls back to the 21 period moving average and
you enter short. Your first target should be the previous
low or monitor closely at that price level.
© Mark McRae
