Average Directional Index indicator

There are many among the investing fraternity who abhor stocks that meander sideways and tend to gravitate towards stocks that are trending upwards or downwards. Traders of course prefer momentum as it helps them to churn their positions faster.

One easy way of picking stocks that are in a strong up or down trend and not in a consolidation phase, is with the use of the Average Directional Index (ADX) indicator. The ADX line is plotted along with two other lines, the +DI and the –DI. The +DI line is the positive directional index and is derived by dividing the range of highs over a period by the price range over the last trading day and the previous close, smoothed over a given number of periods. For calculating the –DI the range of lows is switched with the range of the highs. ADX is the modified moving average of the difference of +DI and the –DI divided by the sum of +DI and –DI multiplied by 100.

There is no need for you to do these calculations manually since most technical software provide the ADX indicator. The ADX is plotted on a scale of 0 to 100. But the indicator scarcely moves above 40. Since ADX is plotted after taking both the +DI and the –DI in to consideration, the slope of the ADX line does not indicate bullishness or bearishness. It just helps the analyst to judge if the stock is in a strong trend or moving sideways.

Once the ADX falls below 20, it suggests that the underlying security is getting in to a sideways move. Conversely, a move above 20 from below would signal that the stock is getting ready to launch in to a strong trend, either up or down. The ADX reversing from 40-level is an indication that the prevalent trend could be reversing.

The ADX is certainly not the easiest of oscillators to interpret or use. The best way to use the ADX is to scan the charts using this indicator and select those stocks that are moving out of the 20 level as that would signal that the stock is moving out of a consolidation phase and is readying to explode upward or downwards.

Via BL