Welles Wilder wrote a book called “New Concepts in Technical Trading,” in 1975. Interested in learning more about the ADX I found the book at one of our local libraries. Welles had developed the ADX indicator for the sole purpose of telling whether price was trending or not. There had always been some nuances which eluded me and seeing his formulas and the step by step number crunching and hand plotting helped me understand what I was looking at when viewing the lines of the ADX.

This article will not endeavor to go over the calculations in depth. But give you a general concept of what is happening. So lets get started. The ADX indicator is formed from 3 lines. The +DI, -DI and ADX

We'll go over the basic construction of the +DI first. The first thing to understand is that the +DI is comparing the current bar's High to the previous bar's High. Please note we are not talking about the close. If the current bar's high is higher than the previous bar's high, you subtract the two highs which gives you the difference. You do this for 14 bars going backward. Sum all the differences together and divide by 14. Now in all probability there won't be 14 higher highs in a row. That's ok, because the next thing you're going to do is calculate the -DI.

The -DI is working with the lows. If the current bar's low is lower then the previous bar's low then you subtract the numbers resulting in the difference. Do this for 14 periods going backward. Add the differences together and divide by 14. This is your -DI number.

You maybe wondering why such detail. The reason is about to appear in the basic operation of the +/-DI. When the +DI is going up nicely, the average +DI number is going up. When the -DI is going up nicely then the average -DI number is going up. Now carefully notice something in these last two statements. The average must keep increasing between the last to trading bars for the +DI or -DI line to continue going up. Therefore in the instance of higher highs the difference between the highs must be increasing in order for the Average Plot Line to continue upward. If the difference between this period's high is the same as the two periods before, then the resulting averages would be the same and the +DI plot would be flat. Therefore the +/-DI numbers are measuring the momentum of the move. There must be some pretty good momentum going to keep pushing the averages upward. As the highs get closer together (or the lows) then the +DI will flatten out and price is loosing steam. You can see this illustrated in the diagram below.

Now for the ADX line. It is essentially constructed by measuring the difference between the +DI and the -DI. When the +DI is skyrocketing upward and the -DI is dropping like a rock the ADX line will be steep. On the up days the higher high averages must be getting larger. On the few down days that exist in such momentum, the lower low would almost be flat. Remember the -DI is going down, not up. The ADX line shows us the strength of the trend.

Another important idea to remember is the ADX line doesn't care if the trend is up or down. It just shows there is a trend. If we were looking at a steep downtrend the ADX line would again be measuring the difference between the -DI and +DI. And again the ADX line would head steeply upward.

How do you tell by looking at the ADX if the trend is up or down? By looking at the +/-DI. If there is a beautiful trend up in price the ADX line will be heading up and the +DI will be above the -DI. If there is a sharp drop in price the ADX line will again be headed up and the -DI will be above the +DI.

So what does it mean when the ADX line is flattening out or dropping? The trend is losing steam or is already over.

Below is a nice example of uptrends and downtrends. Notice where the +/-DI are when the ADX line is headed up. Watch also what happens when the ADX line starts to head down.

So why is 20 circled? Because Welles Wilder says if the ADX line is below 20 you should not be using a trend following system. He also states if the ADX line is below both the +DI & -DI, it is time to stop trading a trend following system. Below is a chart illustrating this.

So lets review the concepts:

In an uptrend-
+DI is above -DI
ADX line is headed up above 20
When the +DI cuts underneath the ADX line price is losing steam.
When the ADX line starts curving down the trend is dying or has already turned.

In a downtrend-
-DI is above the +DI
ADX line is headed up above 20
When the -DI cuts underneath the ADX line price is losing steam.
When the ADX line starts curving down the trend is dying or has already turned.

Well I hope this article was of use to you and maybe shed some light on why the ADX moves like it does and how to use it better to your advantage.

Next week will either be a book review or an insight into the RSI.