The average directional index (ADX) is used to determine the overall strength of a trend. It is one of three components used in the Directional Movement System developed by Welles Wilder, with the other two being the Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI). As the ADX itself in non-directional, measures trend strength only, the -DI & +DI indicators are used to determine the direction of the trend.
The ADX is a moving average of price range expansion, determined by the differences two consecutive highs and two consecutive lows. When the +DI is above the -DI, prices are rising and when the -DI is above the +DI prices are falling with a crossover of the two lines signalling a potential change in trend.
To qualify the strength of the trend, generally a reading above 25 on the ADX signals a strong trend, with readings below signalling weak trend strength that is often accompanied by periods of consolidation. Additionally, when the ADX is rising we can say that the strength of the trend is also increasing, while a declining ADX signals declining strength but importantly does not suggest a trend reversal in itself.
The chart below highlights the price of Nividia Corp. (NVDA) trending higher from May to early September 2020, also evident by the +DI line above the -DI line. We can see in late May the ADX crosses above 25, signalling the strength of the trend is rising. The price continues higher into August where it moves exponentially higher, coupled with a rise in the ADX to over 45. The subsequent fall in price and ADX below 25 signals the increased probably of a period of consolidation with the trend strength fading. The ADX has since remained below 25 and the price continued to consolidate into early December.
The ADX can help identify whether the trend is gaining or losing momentum, or the velocity of price. Where the price and ADX begin to divergence, this signals that there is the heightened risk of a trend reversal or extended period of consolidation. As an example, the chart below highlights bearish momentum divergence, where the price has formed higher highs while the ADX has formed lower highs, signalling momentum is fading.
