ADX (Average Directional Index) is used to analyze the strength of a trend. It is a complex indicator with several moving parts. An in-depth understanding of how to use this indicator will take time. I am going to provide you with a simple explanation of how it is calculated and how it can be incorporated into what I have already explained.
In prior articles, the MACD indicator was explained. It uses closing prices in its calculation.
I bring this up again to make the distinction between MACD and ADX why they are very different and why they can complement one another.
ADX uses the high/low range to calculate the lines. The closes play no factor at all in this indicator. So, MACD uses the closes and ADX uses the range. This is a critical distinction since the market goes through changes in volatility as much as it goes through changes in trend. When volatility expands, the MACD carries more weight and as volatility contracts, the ADX indicator increases in its importance. You can do fine by picking one or the other but each of these indicators provide outstanding signals at times and I believe it is beneficial to understand both.
This is the monthly chart of Visa Inc. (V) from the last section. I have zoomed in on the last few years to show the +DI (Directional Plus) and the -DI (Directional Minus) and how they are derived.
Simply put, the +DI is the strength of the buyers and the -DI is the strength of the sellers. These lines are created independent of one another. Let us start with the buying strength (+DI). The distance between the high of one bar and the bar before it shows us how much the buyers were will pay over and above the prior session. The green arrows and green lines on the chart highlight the distance between the highs. This is Positive Directional Movement (+DI or sometimes called +DM). As a stock makes higher highs, the +DI gets stronger.
On the selling side (-DI), the distance between the low of one bar and the bar before it shows us how much the sellers were willing to take the price down below its prior session. The red arrows and red lines on the chart highlight the distance between the lows. As a stock makes lower lows, the -DI increases in strength.
In ADX, the side with the greatest range wins the bar and that range amount is then added to +DI or -DI. To create the lines for each, we take a simple average and plot them.
The ADX indicator (blue line) is created by taking the difference between these two lines and then plotting it as a moving average as well.
Charles Schaap wrote a book called ADXcellence. This is another outstanding book and it is an in-depth discussion of all aspects of ADX/DI. I recommend it for anyone who truly wants to understand this indicator and its wide variety of uses. Linda Raschke also describes her uses of ADX in some of her books, manuals and videos. Each uses this indicator in a similar fashion with a few modifications.
Schaap uses a 13 moving average of the DI lines. Most software packages use 14 by default so not a big difference there. However, he uses an 8 moving average to create ADX. Standard packages use 14. I adopted Schaaps 13, 8 settings in my analysis and interpretation of ADX. The ADX (13,8) is more responsive to changes in direction than the traditional ADX (14,14) and therefore has more peaks and valleys. This provides more insight into the strength of the last leg and becomes important in determining the strength of a pullback or rally against the trend. For our purposes, this information becomes a vital factor.