One of the toughest problems for traders is deciding when a stock is trending and how strong is that trend. We want to know this because if we can find a strongly trending stock and then wait for its pullback, we will be able to pounce on the stock before it resumes its previous trend. One of the best indicators for finding trending stocks is the Average Directional Movement Indicator or ADX.

The ADX was developed by Welles Wilder and he discusses how to calculate it in the book New Concepts in Technical Trading Systems. Although the entire ADX calculation is somewhat lengthy and complex, understanding the basis of the calculation--directional movement--is fairly straightforward and will help you understand how the indicator works.

The Average Directional Movement Index measures the trend strength of a market but not its direction. Simply, it determines the trend not by looking at the daily prices, but by looking at the high and low prices of each day.  The higher the ADX reading, the stronger the trend, regardless if it is up or down.

Learning how to calculate the ADX is not terribly important. Most professional traders using the indicator have an idea how it works but not the specifics. Most if not all trading programs and platforms have it as a built in function. For you gluttons for punishment and math quants, I will run you through the calculations. Or better yet, get Wilder’s book.

Directional movement is the part of a price bar that falls outside of the prior price bar's range. In terms of a daily chart, price action above yesterday's high is positive directional movement (+DM), while anything below yesterday's low is negative directional movement (-DM).

We must consider two other possibilities: inside days and outside days. An inside day occurs when the entire day's range is "contained" within the prior day's high and low. In other words, today's high is less than yesterday's high and today's low is greater than yesterdays low. For example, if IBM traded yesterday between 127 and 122 and trades today between 124 and 123, then today is an inside day

In the above diagram, there is no DM (either + or -) because the range doesn't trade above (for a +DM reading) or below (for a -DM reading). Inside days have no Directional Movement value

An outside day occurs when today's high is higher than yesterday's high and today's low is lower than yesterday's low. For instance, if IBM traded between 127 and 122 yesterday and between 131 and 1119 today, today is an outside day because today's range is "outside" yesterday's range.

In the above diagram  of an outside day, there is both a +DM and a –DM.

The outside day is an interesting problem because it contains both +DM and  -DM Because there can only be one directional movement (either + or -) per trading day, on an outside day the largest move is the directional movement. In the rare case that the +DM is equal to the –DM,  there would be no DM for that day To make the directional movement readings meaningful for all markets, Wilder divided the DM by the market's true range

True Range

True Range is a volatility calculation developed by Wilder that modifies the standard range calculation by accounting for gaps between price bars. True Range is defined as the largest value (in absolute terms) of:

• today's high and today's low
• today's high and yesterday's close
• today's low and yesterday's close

Average True Range (ATR) is simply a moving average of true range calculated over a number of days. True range and average true range are common volatility measurements This creates a directional movement indicator (DMI) in a form of a ratio and allows for meaningful comparisons regardless of various market prices. In other words, the DMI of a $5 stock can be compared to the DMI of a $100 stock.

The DMI is then averaged over a number of days. The magnitude of the trend reflected by the ADX--longer-term or shorter-term--depends on the number of days in this calculation. Most charting programs use an average of 14 days.

The Average Directional Movement Index (ADX) is then calculated by taking the difference between the smoothed +DMI and -DMI calculations. It's obvious the ADX calculation is very complex, but if you understand the directional movement detailed previously, you'll have a good understanding of how the indicator works and enough background to use it.

Examples

Harmon International. +DMI greater than -DMI reflects an uptrending market. The ADX reading, signifying trend strength, is above 40.

The ADX measures trend strength but not direction. The direction of the market is determined by comparing the +DMI to the -DMI. If the +DMI is greater than the -DMI the market is in an uptrend; if the -DMI is greater than the +DMI the market is in a downtrend. In the above diagram, the +DMI is greater than the -DMI signifying an uptrend.

IBM. A downtrend is reflected by a -DMI reading greater than the +DMI reading. The ADX reading, signifying trend strength, is above 45.

In the above diagram, the -DMI is greater than the +DMI as the ADX remained above relatively high levels (above 30) as the stock continued to decline.

Using the ADX

High ADX readings reflect a strongly trending market. Conversely, low ADX numbers reflect non-trending markets. In general, 14-day ADX readings above 30 suggest a strongly trending market. Those who only wish to trade the strongest of markets may look for readings of 35 or higher. The stronger the number, the longer the trend has been in place. Those who look to catch early trends may look for markets with an ADX of 25 or higher

The advantage of the ADX is that it provides a standardized way of measuring trend. This lends itself well to computerized scans for finding trending markets. These markets can then be watched for potential entries signals from breakouts, breakdowns, pullbacks and cup-and-handle.