ADX Directional Movement Index
This article will be looking at another one of Welles Wilder Jr creations, the ADX Directional Movement Index. The Directional Movement Index (DMI) can be used in conjunction with another indicator - the Parabolic SAR as it's primary objective is to enable identification of a trendline and indicates buy or sell signals.
Application
The DMI system is made up of three separate lines, the +DI (up average), the -DI (down average) and the ADX ( Average Directional Movement Index) which indicates whether a trend is in effect by smoothing the difference between the +DI and the -DI.
The ADX is a number between 0 and 100. A rising ADX line indicates that the price is trending, some technical analysts believe that the ADX has to be greater than 20 or 25 to suggest a trending market. Conversely, a falling ADX suggest the share price is not trending. Therefore, when the ADX line rises through the 20 to 25 level many believe this is a firm indicator that the price will begin to trend.
The DMI system generates two basic buy and sell signals. A buy signal is generated when the +DI crosses above the -DI line, and a sell signal is generated when the +DI signal crosses below the -DI line.
Practical Application
The chart below is of Qantas (QAN) from May 2006. The chart below has the ADX line in red, the +DI line in blue and the -DI line in black. The Qantas chart below also shows the Parabolic SAR line (dotted black line).
As you can see above the aqua circle indicates an area where the +DI (blue line) moved above the -DI (black line) for only two days, the downward slanting ADX line (red line) would have provided good evidence to ignore the signal.
The highlighted yellow area indicates a period when the +DM and -DM lines cross over several times, however again the ADX is downward slanting which suggested that these may have been false signals, that is, the share price is not trending.
Eventually, in the highlighted yellow area the +DM line crosses above the -DM line suggesting a buy signal. This signal would have been confirmed in the subsequent days when the ADX line moved above 20 and by the Parabolic SAR (green circle) that indicated a buy signal, this would have confirmed the DMI crossover signal.
