The Average Directional Index (ADX), developed by J. Welles Wilder Jr. and also sometimes called the Direction Movement Index, or DMI, is used to evaluate the strength of a trend, be it up or down. The ADX indicates when a trend is present and the overall strength of the trend. The higher the ADX the stronger the trend.
The ADX system comprises three lines; +DI,–DI and the ADX line.
A) Positive Directional Indicator (+DI; thin green line) indicates the strength of upward price pressure
B) Negative Directional Indicator (–DI; thin red line) indicates the strength of downward price pressure
C) Average Directional Index (ADX line; thin black line) shows the overall strength of a trend without regard to direction. The higher the ADX, over 20, the stronger the trend.
The ADX line combines +DI with –DI and then smooths the data with a moving average to provide a measurement of trend strength. Because it uses both +DI and –DI, ADX does not offer any indication of trend direction, just strength. The ADX line fluctuates between 0 and 100, and readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend, and high readings above 40 indicate a strong trend.
The ADX line can also be used to identify potential changes in a market from non-trending to trending. When ADX begins to strengthen from below 20 and/or moves above 20, it is a sign that the trading range is ending and an upward or downward trend could be developing.
The ADX indicator is traditionally interpreted as follows:
An ADX line rising above 20 indicates that a trend may be forming
+DI crossing above –DI is a buy signal
–DI crossing above +DI is a sell signal
The ADX line falling below 40 is an early indication of a change in trend
The ADX line should be between the DI lines when the market is trending
An ADX line below 25 indicates no particular trend is in place
Below is an example of IBM and its ADX indicator. Vertical line A shows an early stage of a deteriorating market about 2 1/2 months before the October 2008 crash. At this point the price chart still looks somewhat healthy where IBM is trading above its 100 day simple moving average (SMA; thick blue dotted line), and the 20 day SMA (thin blue line) is oscillating above and below its 50 day SMA (thin black line). However, we can see an early bearish indicator in the ADX line where the red line has crossed above the green line.
Three weeks later vertical line B shows the price chart getting weaker where the stock has dropped below all of its major simple moving averages, including its 200 day line. (thick black dotted line). At this point the ADX is telling us that bearishness is increasing since the red line has climbed and the green line has dropped. We can also see the ADX line (thicker black line) is trending upward, telling us that a bearish trend is probably forming.
Three additional weeks later we see that the stock has been trying to find support at its 200 day SMA. However, its 20 day SMA has crossed below its 200 day SMA, which is a bearish signal. Additionally, we see negative divergence where the price chart is attempting to find stability at its 200 day line, but the ADX line is trending upward, shown via the trend line as drawn, telling us that a bearish trend is attempting to form.
Finally, 1 1/2 weeks later at vertical line D, we see that the stock is dropping hard and that the ADX line crossed above its center line, telling us that a bearish trend is gathering strength. These were some of the best early indicators telling us to sell our stock or to close-out our bullish or sideways option trades.