DI+ = Average of X periods [Current High – Previous High]/(Average of X periods of the True range)
DI- = Average of X periods [Current Low- Previous Low]/(Average of X periods of the True range)
DX = 100 * ((DI+)-(DI-)/(DI+)+(DI-))
So what is the indicator telling us ? Mainly the higher the values of DI+ or DI- the higher the difference between the current and past highs/lows becomes relative to the largest movement observed within the current and last candle X period average. However note that DI+ and DI- are not normalized and therefore we can only interpret them relative to each other. A higher value of DI+ over DI- indicates that in average higher highs where achieved while a value of DI- above DI+ indicates the opposite. The DX – which is normalized – compares the difference between DI- and DI+ and tells us what percentage this difference represents from the sum of both indexes. The value of DX will be higher as the difference between DI+ and DI- becomes larger effectively showing that during the past X periods the market has shown a prevalent movement in one direction.
The fact that the DX value seems to be related with prevalent market movement then does not imply that we can define trends/ranges clearly from the ADX. There are two reasons why this is mainly not a good use of the ADX indicator. First of all, the DX line is comparative meaning that if we have a quiet market period with low volatility but a steady up/down movement the indicator may interpret it as a trend. The second problem is related to the fact that you would have to select a “level” to use as a threshold between “ranging and trending” conditions, something which cannot be easily done. Usually if you attempt to enter trades in favor of “the trend” when the DX value is high you will find that the trend has already happened and you are just entering too late.
The ADX indicator however can be used to detect retracements given the fact that it can detect when a weakening from a previously strong trend has happened. For example, if the ADX reaches an extreme value (indicating strong market momentum) we could simply wait for a weaker DX value and enter the trade in the direction of the trend when the trend has apparently “ceased”. Of course, we will enter upon a retracement, within a very good position to take advantage of future movements. Such a case is exemplified within the following chart.
As you see, the ADX indicator can be used for this type of purpose successfuly, not taking into account any range/trend filtering characteristics which are generally attributed to this trading tool. We take advantage of the fact that the indicator signals “what has already happened” and we use it to enter trades in favorable positions to exploit a tradable market inefficiency. Of course, developing a mechanical trading strategy based on this concept would require the development of additional closing criteria and trade analysis (to see which DX levels are adequate) but such an approach is bound to be a good start to develop a long term profitable strategy based on the ADX indicator.
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